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William & Mary Annual Tax Conference Conferences, Events, and Lectures

2001

Tax Planning for Real Estate DevelopersCharles H. Egerton

Copyright c 2001 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository.https://scholarship.law.wm.edu/tax

Repository CitationEgerton, Charles H., "Tax Planning for Real Estate Developers" (2001). William & Mary Annual Tax Conference. 165.https://scholarship.law.wm.edu/tax/165

TAX PLANNING FOR REAL ESTATE DEVELOPERS

By

Charles H. Egerton, Esq.Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.

Orlando, Florida

TAX PLANNING FOR REAL ESTATE DEVELOPERS

Table of Contents

I. Factual Background ....... ................

A. Description of property and introduction ofcharacters . . . . . . . . . . . . . . . . .

B. Financial and tax data ...........

C. Plans for development ..... .............

I. Sale of Property Alternative Proposals .......

A. Installment sale with assumption of existingmortgages ....... ...................

B. Installment sale with wraparound mortgage . .

C. Installment sales with participation feature

D. Rolling options ...... ................

I. Exchange of Properties ...... ..............

A. Developer's proposal ............

B. Tax implications to Trumpets ........

:V. Partnership Proposal ...... ................

A. Description of proposal .... ............

B. Tax consequences to the Trumpets and TLLC . .

C. Tax consequences to Tiger Nicklaus .....

D. Tax consequences to Developer ............

E. Tax consequences to partnership ..........

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TAX PLANNING FOR REAL ESTATE DEVELOPERS

By

Charles H. Egerton, Esq.Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A.

Orlando, Florida

I. Factual Background

A. Description of property and introduction ofcharacters. Donald Trumpet and his wife Nervanna,are highly successful real estate investors in theCentral Florida area. As early as 1985 Donald andNervanna anticipated major population growth westof Orlando. During the past decade the Trumpetshave quietly assembled 3,000 acres of contiguousland known as the Taj Mahal Grove, which islocated close to a major roadway between Orlandoand Walt Disney World. The Trumpets' foresightwas further rewarded by a recent announcement thatthe proposed beltway to be constructed aroundOrlando will pass close to their property and amajor interchange is planned within a quarter-mileof a portion of their property. The propertyconsists of approximately 1,000 acres of orangegrove with the balance comprised largely ofundeveloped pasture land. The Trumpets operatedthe grove at a modest profit until December 1989when the trees were all destroyed by a majorfreeze. The Trumpets determined not to replantthe grove and have ceased all activities withrespect to the care and maintenance of the trees.

The property is situated around three large springfed lakes that have historically providedirrigation for the groves. The pasture land isleased out to ranchers who pay the Trumpets asmall sum for the right to graze their cattle onthe property. Approximately 10% of the Taj MahalGrove is comprised of wetlands which areenvironmentally protected and may not bedeveloped.

Several properties in the vicinity of the TajMahal Grove have recently been acquired by aprominent local developer who has announced plansfor the development of both a major residentialcommunity and an office park. The Trumpets areconstantly besieged by inquiries from bothdevelopers and land specu Iators who haverecognized the significant potential of the TajMahal Grove property for a major development, Zutthe Trumpets have thus far refused to discussdisposition or development of the property withanyone.

The long awaited announcement of the route for thewestern beltway caused the Trumpets' property toescalate substantially in value and they recentlyconcluded that the time may be ripe to eitherdis pose of the Taj Mahal Grove or, alternatively,participate in some manner in the ultimatedevelopment and sale of the property. Althoughthe Trumpets are knowledgeable real estate

investors, they have never engaged in thedevelopment of any of their roperties, preferringinsteaa to sell or exchange their properties androll their investment into new properties withsignificant upside potential. However, theTrumpets have studied the Central Florida realestate market carefully and have concluded thatthe location and natural amenities of the TajMahal Grove together with the westward expansionof the Greater Orlando urban sprawl, all point tothe conclusion that a well planned mixed usedevelopment on their property could be immenselyprofitable. They have, therefore, decided toexamine all of their options with respect to theTaj Mahal Grove.

The Trumpets recently commenced discussion withTrammel Crowbar, whose corporation, CrowbarDevelopment Co. ( Developers), is one of thenations largest evelopers of both residentialand commercial properties. The Trumpets believethat Developer is an ideal candidate to eitheracquire the Taj Mahal Grove or to enter into ajoint venture to develop the property. Crowbarbecame aware of the Trumpets' property afterreceiving a mailing from the Trumpets trustedsecretary, Sugar Maples. After investigation ofthe property, Developer has concluded that it willbe a premiere site for an upscale mixed usedevelopment project. Mr. Crowbar informed theTrumpets that he is willing to discuss an outrightpurchase of the Taj Mahal rove, a like kindexchange, a joint venture arrangement or any otherapproach that will meet the Trumpets' reasonabletax and business objectives.

B. Financial and tax data. The Trumpets acquired theTaj Mahal Grove in three separate transactions.The first parcel, consisting of 1,000 acres(sFirst Parcell) was acquired in 1985 for $1,000er acre or a total purchase price of $1 000,000.he Trumpets acquired the First Parcel wilth fundsinherite from Donald's uncle. The secondpurchase was made in 1986 and consisted of 1,500acres (sSecond Parcels) which the Trumpetspurchased for $4,000 per acre or a total purchaserce of $6,000,000. The total purchase price of6,000 000 was properly allocated $1,000,090 to

the citrus trees located on the property with thebalance ($5,000,0001 allocable to the land. TheSecond Parcel was financed equally with equitycapital of the Trumpets and purchase moneyfinancing. However, in order to raise cash neededfor another investment the Trumpets refinanced theSecond Parcel in early 2000 which resulted in anew mortgage (replacing the prior purchase moneymortgage) of $6,000,000 bearing interest at 8%which now encumbers only the Second Parcel. Thefinal purchase was a smaller 500 acre tract(Thir Parcels) acquired in the latter part of196 in order to gain more road and lake frontageand to otherwise square off the Trumpets' propertyand make the overaIl tract more marketable. Thisproperty was acquired at $8,000 per acre and was

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financed by $1,000,000 of the Trumpets' own fundslus a purchase money mortgage in the amount ofV3 000,000.which also bears interest at 8%, all ofwhich remains outstanding.

The citrus trees, which are located on the SecondParcel, have been fully written off for federalincome tax purposes through a combination ofdepreciation and casualty loss (from the 1989freeze) deductions. Thus, the adjusted tax basisof Second Parcel has been reduced to $5,000,000.The current fair market values, tax bases, andmortgage balances of the three parcels are asfollows:

Fair Market Adjusted MortgageValues Tax Basis Balance

First Parcel $ 10,000,000 $ 1,000,000 $ -0-Second Parcel 15,000,000 5,000,000 6,000,000Third Parcel 5,000,000 4,000,000 3,000,000

Totals $ 30,000,000 $10,000,000 $ 9,000,000

The Trumpets are cash basis taxpayers who operateon a calendar year for federal income taxpurposes. Florida does not impose an income taxon individuals and state income taxes will,therefore, be ignored.

C. Plans for development. Developers' engineers andland planners have proposed a preliminarydevelopment plan for the Taj Mahal Grove whichcalls for a multi-use project to be developed andsold in four phases with a projected sell-out overa period of eight to ten years. The plan includesan office park, a shopping center, a residentialcommunity consisting of both half-acre and one-acre residential lots together with clusters oftownhomes. The planned amenities include twochampionship golf courses, a tennis center, a parkand a marina located on the largest lake whichwill be designed for sailboats and houseboats.

II. Sale of Property -- Alternative Proposals. Crowbar hasreceived and reviewed all of the preliminary reportsfrom Developer's planners, including pro formaprojections on various alternatives for development ofthe Tai Mahal Grove. He has also consulted Developer'stax attorneys and CPAs to assist in structuring severalalternative proposals for the purchase of the propertythat will meet both Developer's cash flow requirementsand the tax and economic objectives of the Trumpets aswell. Each of Developer's proposals will be describedand analyzed below.

A. Installment sale with assumption of existinQmortqages.

1. Description of proposal. The first proposalcontemplates a purchase of the entire Ta]Mahal Grove by Developer from the Trumpetsfor $30,000,000, payable as follows:

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$ 5,000,000 Down payment at closing(includes $1,000,000 deposit)

9,000,000 Assumption of existingmortgages

16,000,000 Purchase money note and

$30,000,000 mortgage

The purchase money note calls for payments ofinterest only at 10% per annum, payableannually for two years. Thereafterprincipal will be paid in annual installmentsof $1,o00 000 per year plus interest accruedon the outstanaing principal balance for aperiod of five years, and with a balloonpayment due on he 8th anniversary of theclosing. In addition, the mortgage willcontain provisions for the release ofcommercial lots, residential lots andtownhome sites at set prices determined bythe size and location of each lot, and suchprices are to be revised annually after thethird anniversary of the closing date forincreases in the Consumer Price Index.Developer intends to seek a modification ofthe existing mortgages to also accommodatereleases and subordination, but if it isunsuccessful in obtaining such amodification Developer has the right torefinance both mortgages in which case theTrumpets will be required to subordinatetheir purchase money note and mortgage tosuch refinanced debt. Lands earma ked inDeveloper's development plans (the WandPla for the entryway, streets, medians andamenities (golf courses, tennis courts,parks, etc.) may be released from themortgage upon payment of $1,000 per acre andupon Developers posting of a payment andperformance bond assuring construction ofthese improvements in accordance with theLand Plan. The Land Plan is subject to theTrumpets' prior approval. The purchase moneynote and mortgage also require the Trumpetsto subordinate to a development loan, theproceeds of which will be utilized to developthe Taj Mahal Grove in accordance with theLand Plan. o

2. Character of income. Gains from sales orexchanges by non-corporate taxpayers such asthe Trumpets of capital assets held for morethan one year as well as certain net §1231gains are now taxed at a maximum rate of 20%?a maximum rate of 10% will apply fortaxpayers in the 15% tax bracket). Sl(h).However, gains from the sale of depreciablereal property will be taxed at a maximum rate

.of 25% to the extent of unrecaptured §1250gains. By contrast, the maximum rate imposedon the ordinary income of a non-corporatetaxpayer is 39.6%. In the case ofindividuals, the effective rate applicable toordinary income can be increased by an

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additional 1.188% under §68 by limiting theuse of itemized deductions and by anadditional 0.67% under §151(d)(3) by phasingout the personal and dependent exemptions.When these are combined, the maximumeffective rate on ordinary income forindividual taxpayers can be as high as41.458%. Thus, there is a potentialdeferential of as high as 21.458% between themaximum long term capital gain rates and theordinary rates of individual taxpayers.

a. The portion of the Trumpets' propertythat has been operated as an orangegrove may be classified as a §1231 assetpursuant to §1231(b), but theabandonment of all grove operations inDecember 1989, and the subsequentdecision of the Trumpets to hold theproperty for future appreciation willprobably be deemed to have converted theproperty from a trade or businessproperty to a capital asset held as aong term investment. See, §1221.

b. The balance of the property will qualifyas a capital asset under S 1221 becausethe Trumpets have held the property as along term investment, have neverdeveloped it and have not otherwiseengagea in any dealer activitiesi withrespect to the land.

(1) The passive ground lease of theremainder of the property toranchers as pasture 1and willprobably not be sufficient tocharacterize this portion of theropertT as §1231 property under1231(b .

c. It is possible that a small portion ofthe Trumpets' gain will be convertedfrom long term capital gains to ordinaryincome. Citrus trees are S1245properties as defined in Reg. S1.1245-3(b)(1). The lesser of the recomputedbasis of the trees or the gainattributable to the trees will berecharacterized as ordinary income under§1245(a). However, since the trees wereall either killed or severely damaged bythe freeze, and since Developer intendsto remove all of them in the course ofdeveloping the property, the parties mayproperly allocate zero or minimal valueto the trees which will eliminate (orvirtually eliminate) any S1245recapture. Note: the allocation rulesof §1060 will not apply to this salebecause there has been no sale ofassets which constitute a trade orusiness.1 See, S§1060(a) and (c).

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(1) Caveat also possible application of§1231(c) which provides for therecapture of certain prior §1231loss deductions taken during thefive most recent preceding taxableyears upon disposition of a §1231asset.

d. Classification of the Trumpets asinvestors rather than dealers withrespect to the Taj Mahal Grove is alsovery important in an installment sale.Gains from the sale of most dealerproperties are no longer eligible forinstallment reporting. See,S§453(b) (2) (A) and 453(i).

3. Installment reporting -- Eligibility andBasic computations. The Trumpets will beeligible to report their gains from the saleof their property under Developer's firstproposed alternative on the installmentDasis.

a. Under the installment reporting method,a portion of each payment received bythe Trumpets must be reported as income.The portion to be recognized as incomeis determined by multiplying the amountof payment by a fraction, the numeratorof which is the ross profit and thedenominator is t e total contractprice (i.e., the 1ross profitpercentages). Temp. Reg. S15A.453-1(b) (2) (1).

(1) vGross profito is the selling priceess the Trumpets' adjusted basis

in the propert Temp. Reg.§S5A. 453-1(b) )(v) .

(2) !Total contract pricei is theselling price less Nqualifyingindebtedness assumed or takensubject to y the buyer to theextent that such qualifying indebt-edness does not exceed theTrumpets' basis. Temp. Reg.$15A.453-1(b) (2) (iii). Qualifyingindebtedness generally means debtencumbering the property, subjectto certain limitations. See, Temp.Reg. §S5A.453-1(b) (2) (iv).

b. Installment reporting is mandatoryunless the Trumpets select outa under§453(d) by filing I.R.S. Form6252 witha timely iled return (includingextensions) for the taxable year inwhich the closing takes place. Temp.Reg. §15A.453-1(d)(3)(i). The election,once made, may not be revoked withoutthe consent of the I.R.S. §453(d).

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C. If the Trumpets have any §1245recapture, the entire amount of therecapture income must be recognized inthe taxable year in which the closingoccurs, regardless of the amount ofpayments received in such year.§453 (i).

d. If the 10% interest rate provided in thepurchase money note is less than theapplicable feral rate a portion ofthe payents due under the note will betreate as original issue discount(NOIDI), and both the timing and theamount of income to be reported byreason thereof will be governed byS§1272 through 1275.

(1) The limited relief from the generalrules of §1274 which is affordedunder S1274A would not be available(if needed) to the Trumpets becausethe Istated principal amounts ofthe purchase money note exceedsboth the $2,800,000 threshold forS1274A(b) and the $2,000,000requirement of S1274A(c).

e. The computation of the amount of gain tobe recognized by the Trumpets in theyear of sale under §453 (assuming no1245 recapture, no OID and ignoringselling expenses) is as follows:

Gross Profit: $30,000,000 Selling Price-10,000,000 Adjusted Tax

Basis$20,000,000

Total ContractPrice: $30,000,000 Selling Price

- 9,000,000 Qualified DebtAssumed

$21,000,000

Gross Profit Percentage:

$20.000.000 Gross Profit = 95.24%$21,000,000 Total Contract Price

Gain to be Recognized in Year of Closing:

$5,000,000 Payment x 95.24% Gross ProfitPercentage = $4,762,000

f. If qualifying debt assumed or takensub)ect to exceeds the Trumpets' basis,such excess will be treated as anadditional payment to the Trumpets atclosing. Temp. Reg. S15A.453-l(b)(3)(i). If the sales of the First,Second, and Third Parcels are aggregated

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and deemed to constitute the sale of asingle property the mortgage balanceS$9,000,00) wil1 not exceed theTrumpets' basis ($10,000,000). On theother hand, if each parcel is viewed asa separate sale, the mortgage balance onthe econd Parcel ($6,000,000) exceedsthe adjusted basis of such parcel($54000,000) which could result in anadditional payment of $1 000 000 in theyear of sale. Although the law on thisissue is not crystal clear, it appearslikely that the Trumpets will be able toaggregate the parcels into a single salebecause the parcels are contiguous, theywere offered as a unit the contract andall closing documents treat them as asingle unit and they are also similarreal properties. Compare, Veenkant v.Commissioner, 416 F.2d 93 (6th Cir.1969); with Charles A. Collins, 48 T.C.45 (1967),a. 1967-2 C.B. 2; RichardH. Pritchett,-63 T.C. 149 1974), aca.1975-2 C.B. 2; and Rev. Rul. 76-110,1976-1 C.B. 126.

4. Toll charge for privilege of usinginstallment method. Section 453A(a)(1)imposes a toll charge in the form of intereston certain installment obligations arisingduring the taxable year.

a. The interest charge imposed under§453A(a)(1) a plies to an installmentobligation (,SON) arising from a saleof property,-ut only if the sellingprice of the property exceeds $150,000.S453A(b) (1). Since the sale of theTrumpets' property under this firstproposed alternative is $30,000,000,his condition is met.

(1) ISOs from the sale by an individualtaxpayer of personal use propertyjas defined in §1275(b)(3 ) andISOs of any taxpayer arising fromthe sale of property used orproduced in the trade or businessof farming (within the meaning ofS2032A(e)(4) or (5)) are notsubject to the interest toll chargerovsons. see, S453A(b)(3).rthough the Second Parcel wouldpreviously have qualified asroperty used in the business offarming, the abandonment of allgrove activity at the end of 1989would preclude the Trumpets frombenefiting from this exception.Moreover, the passive ground leaseof the balance of the land tofarmers for a nominal price willlikewise not qualify.

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b. In addition, even if an ISO arises fromthe sale of property with a sellingprice in excess of $150 000, theinterest toll charge will not apply toany such ISOs which are received by theTrumpets during 2001 (the taxable yearin which the closing on the Taj MahalGrove would take place) unless the faceamount of all such ISOs which firstarose in 2001 and which are stilloutstanding on December 31, 2001,exceeds $5,000,000. §453A(b)(2). Evenif the ISO from the sale of the TajMahal Grove is the only ISO of theTrumpets which arose in 2001, thissecond test will also be met because theISO will have a face amount of16,000,000 (i.e., well in excess of the5,000,000 threshold).

c. If an ISO once becomes subject to theinterest toll charge imposed by§453A(a)(1) the charge will apply everyyear until the ISO is either fully paidor is otherwise disposed of. See,§453A(c)(1). Thus, the TrumpeEsmustpay interest on the Taj Mahal Grove ISOin 2001 and in every year thereafteruntil it is paid off or disposed of.

d. The method for computing the interestcharge with regard to the Taj Mahal ISOis set forth in S453A(c). The interestcomputation can be expressed as aformula as follows:

Applicable Percentage x Deferred TaxLiability x §6621(a) (2) Under-payment Rate = Interest

(1) The pplicable Percentage4 for theTaj ahal ISO will be determined asof December 31, 2001 (the year inwhich the ISO arose) and willremain constant throughout theentire period that it is held bythe Trumpets. The ApplicablePercentage is determined bydividing the excess of theaggregate face amount of all ISOswhich arose during 2001 and whichare sub ject to §453A(b)(2) over$5,000,000, by the a regategfraceamount of all such ISOs.S453A(c)(4j. Thus, the lApplicablePercentage for the Taj ahal ISOwould be computed as follows:

($16.000.000 - $5.000.000) = 68.75%S16,000,000

(2) The IDeferred Tax Liabilit withrespect to the Taj Mahal Im at theend of any taxable year will be

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equal to the amount of gaininherent in the ISO which has notget been recognized as of the lastay of such taxable year, multi-plied by the maximum rate of taxapplicable to individual taxpayersfor such taxable year.§453A(c)(3). Note that, if thegain is treated as long termcapital gains, the maximum ratewi 1 be the maximum rate underSlih) (currently 20%). TheDeferred Tax Liability of theTrumpets with respect to the TajMahal ISO as of December 31, 2001(assuming no rate changes betweennow and such date) will be computedas follows:

$15,238,000 Unrecognized Gain as of12/31/01 in Taj Mahal ISO*

x .20 Maximum §(h) Tax Rate$ 3,047,600 Deferred Tax Liability as

of 12/31/01

The amount of unrecognized gain inthe Taj Mahal ISO is computed bymultiplying the outstanding unpaidbalance of the ISO ($16 000,000) bythe ross profit percentage(95.24%).

Since the amount of theunrecognized gain with respect tothe Ta) Mahal ISO will change eachtime a payment of principal ismade, and individual tax rates arealso subject to change at the whimof Congress, the Deferred TaxLiability is subject to changeevery year (in contrast to theApplicable Percentage which isalways a constant).

(3) The underpayment rate under§6621(a)( ) will be determined asof the ast month of each taxableyear in which the interestcalculation is made. It will beassumed for purposes of thisoutline that the underpayment rateis 10%.

(4) In summary, if the Trumpets soldthe Taj Mahal Grove to Developerunder this first alternative, theinterest toll charge computed under§453A(c) with respect to the TajMahal ISO for 2001 would be asfollows:

68.75% (Applicable Percentage) x$3,047, 600 (Deferred Tax Liability)

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x 10% (Underpayment Rate) =$209,523

(a) It should also be noted that afull year's interest will becharged for each and everyyear to which the interesttoll charge applies. Thus, ifthe Trumpets closed on thesale of the Taj Mahal Grove onDecember 1, 2001, they wouldstill be required to pay afull year's interest for 2001even though the deferred gainwill have only beenoutstanding for a period ofone month during that year.Consequently, the Trumpetsshould attempt to defer theclosing until January if atall possible and avoid thissubstantial interest chargefor 2001.

(5) Section 453A(c) (1) provides that ifthe toll charge under §453A(a)(1)applies, the 3 . . . tax imposed bythis chapter #or such Taxable yearshall be increased by the amount ofinterest . . . I computed under§453A(c). Although this raises aquestion as to the nature of thecharge (i.e. whether it is a 3taxlor jinterest4), §453A(c)(5), whichwas added by he RevenueReconciliation Act of 1989 (the'89 Actl), now clearly providesthat such amount will be treated asinterest for purposes of testingfor deductibility under §163.Congress presumably referred to theinterest charge as an increase tothe seller's tax in order to enablethe IRS to assess and collect theinterest in the same manner as atax deficiency. Thus, the interesttoll charge imposed upon theTrumpets for 2001 will benondeductible personal interestunder §163(h). Reg. §1.163-9T(b)(2); Miller v. United States,65 F3d 687 (Sth Cir.1995); and J.E.Redlark v. Commissioner, 98-1 USTC50,322 9th Cir. 199), reversinghe Tax Court.

5. Application of pledge rules. Section 453A,which was first enacted as part of theOmnibus Budget Reconciliation Act of 1987( OBRA) not only imposed an interest tollc arge, but also sub ected any ISOs arisingfrom sales with a selling price in excess of$150,000 to the new pledge rules found in§453A(d). Thus, if the Trumpets pledge the

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Taj Mahal ISO to secure indebtedness of anykind, the net proceeds from such securedindebtedness will be treated as a paymentreceived on the ISO as of the later of (i)the time at which the indebtedness firstbecomes secured, or (ii) the time theproceeds of such secured indebtedness areirst received by the Trumpets. §453A(d) (1).

However, the amount treated as received underthe pledging rules by reason of any securedindebtedness cannot exceed the excess (ifany) of the total contract price under theIS. over any portion of the total contractp rice previously received under the contractbefore the secured indebtedness was incurred(including amounts previously treated asreceived under the pledge rules).§453A(d) (2).

B. Installment sale with wraparound mortQaqe.

1. Description of proposal. Developer's secondproposal to acquire the property is identicalto he first except that, in lieu of assumingthe existing $9,000,000 of mortgages securingthe property and giving a purchase money noteand mortgage for $16,000 000, Developer willgive the Trumpets a single purchase moneymortgage in the amount of $25,000,000,bearing interest at 10% per annum which will!wrap aroun the two orl ginal mortgagesencumbering he second and third parcels (theOriginal Mortgagesl). The mortgage iscalled a B.raparoun mortgagej because theTrumpets will continue to be responsible forthe Original Mortgages, including the paymentof all principal and interest due thereunder.The wraparound mortgage will contain the sameterms and conditions (except with respect tothe principal amount and the interest rate)as the purchase money note and mortgagedescribed in the first proposal but, as acondition to this proposal, the Trumpets mustobtain a modification of the OriginalMortgages to include release provisions thatwill work in tandem with the releaserovisions of the wraparound mortgage. Note

that the Trumpets should (if possible)negotiate release prices under the OriginalMortgages lower than the release prices underthe wraparound mortgage to insure that theywill receive sufficient cash to both securethe release of the applicable portion of theproperty from the Original Mortgages and tohave enough cash left to cover their taxliability on the payment received by themunder the wraparound mortgage.

2. General considerations.

a. From a nontax perspective, thewraparound purchase money mortgageprovides the Trumpets the opportunity tocontinue to benefit from the favorable

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terms of the Original Mortga esincluding the 8% interest rae (therebyenjying the benefit of the 1spreadfbetween the 10% interest rate paid yDeveloper under the wraparound mortgageversus the 8% rate the Trumpets must payon the Original Mortgages).

b. The principal tax issue is whetherDeveloper will be deemed to haveacquired the property subject t the$9,000,000 balance of e riginalMortgages. The consequences stemmingfrom the resolution of this issue aresignificant to the Trumpets.

(1) If the property is determined tohave been conveyed Isubject toa theOriginal Mortgages, the Trumpetsmay be deemed to have received anadditional payment in the year ofsale equal to the excess of the$6 000,000 principal balance on theoriginal Mortgage encumbering theSecond Parcel over the adjustedbasis in the Second Parcel of$5,000,000, or $1,000,000. SeeTemp. Reg. $15A.453-1(b)(3)(1-15;see also, discussion of the issueof whether the First, Second andThird Parcels can be aggregated andtreated as a sale of a singleproperty under Part II.A.3.(f),supra. In addition, the grossprofit percentage the Trumpets mustapply to the payments received inthe year of sale will be increased.

(2) The Service, in Temp. Reg.§15A.453-1(b)(3)(ii) provided thatany conveyance of property which isencumbered by a rior liabilitythat is purportedly Wrappedaroun y a new purchase moneymortgage, will be deemed to havebeen conveyed subject to theexisting debt.

(3) Temp. Reg. §15A.453-1(b) (3) (ii)requires the computation of a grossprofit percentage which is to beapplied to ayents in the year ofsale (computedin the normalfashion) and a separate grossprofit percentage for thewraparound note and mortgage. Thecalculations called for under theRegulations are as follows(assuming that there will be noadditional payment in the year ofsale because of a mortgage inexcess of basis and assuming noprepayments for releases):

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Selling Price

Contract Price

Gross Profit

Gross Profit Percentage

Taxable Gain inYear of Sale

$ 30,000,000

$ 30,000,000- 9000,000

$ 21,000,000

$ 30,000,000-10,000,000$ 20,000,000

20,000,00021,000,000

$ 5,000,000x .9524

$ 4,762,000

Selling PriceMortgage taken subject to

Selling PriceBasis

= 95.24%

PaymentGross Profit Percentage

Calculations with respect to thewraparound note and mortaQe are asfollows:

Basis in Wrap Note:

Gross Profit inWrap Note

Gross Profit Percentagefor Wrap Note

(4)

Selling Price

Contract Price

Gross Profit

Gross Profit Percentage

Taxable Gain inYear of Sale

$ 10,000,000+ 4,762,000

- 5,000,000$ 9,762,000

$ 25,000,000- 9.762,000$ 15,238,000

Basis in PropertyGain Recognized in Yearof SaleCash received

Face AmountBasis

15,238,000 60.95%25,000,000

The Trumpets' contention is thatthe Original Mortgages were neitherassumed nor taken subject to.Under this approach thecomputations would be as follows(with the same assumptions as notedabove):

$ 30,000,000

$ 30,000,000

$ 30,000,000-10,000,000$ 20,000,000

20,000,00030,000,000

$ 5,000,000

(no reduction forOriginal Mortgages)

Selling PriceBasis

= 66.67%

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x .6667$ 3,333,500

(5) Comparison of timing of recognitionof gain:

Taxpayer'sYear IRS Approach Aproach

1 $ 4,762,000 $ 3,333,5002 -0- -0-3 609,500 666,7004 609,500 666,7005 609,500 666,7006 609,500 666,7007 609,500 666,7008 12,190,500 13,333-000

$20,000,000 $20,000,000

(6) The interest toll charge leviedunder §453A(a)(1) (see, discussionunder Part II.A.4., subra) willalso apply to the wraparound note.As previously noted, the interesttoll charge is applied to thedeferred tax liability (the amountof unrecognized gain inherent inthe note as of the end of aparticular taxable year). If thewraparound mortgage is respectedfor federal tax purposes € theamount of deferred tax liabilitywill be greater (especially in heearly y ears) than in the case of aconventional purchase money notecoupled with an assumption of theOriginal Mortgages. This willalways be true because the use of awraparound mortgage defersrecognition of gain longer than inthe case of a conventionalassumption. Thus, §453A dilutesthe tax benefits associated withdeferral that are otherwiseavailable when a wraparoundmortgage is used.

3. Status of the law with respect to wraparoundmortgages. The tax treatment of wraparoundmortgages has, until recently, been anunsettled issue.

a. Early conditional sale cases supporttaxpayer's position. The StonecrestCorporation v. Commissioner, 24 T.C. 656(1955), non-ac ., 1956-1 C.B. 6; Estateof Lambert v. Commissioner, 31 T.C. 302S1958), non-acq., 1959-1 C.B. 6i andnited Pacific Corp. v. Commissioner, 39

T.C. 721 (1963).

b. Later cases involving purportedwraparound mortgages held for IRS, butin each instance the Court dodged the

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principal issue and held that, on theacts before it, the purchaser hadactually assumed or taken sub ect to thepre-existing mortgage. See, Voiaht v.Commissioner, 68 C. 99(T1977,1,affd.per curiam, 614 F.2d 94 (1th Cir.9-80);Waldrep v. Commissioner, 52 T.C. 6401969) € aff'd per curiam, 428 F.2d 1216(5th Cr. 197 0); and Goodman v.Commissioner, 74 T.C. 684 (1980).

c. After passage of the Installment SalesRevision Act of 1980 (the lInstallmentSales Actf), a substantial portion ofthe installment reporting rules waschanged. The Service took advantage ofthis situation and included the anti-wraparound mortgage provision found inTemp. Reg. S15A.453- discussed supra.HoweverI the Service's position in thisregard is questionable since theinstallment sale provisions added by theInstallment Sales Act did not alter therules regarding the computatiFon of

ross profit percentage.l Theervices proposed regulation, as itapplies to wraparound mortgages, wascriticized on several grounds includingthe following:

(1) It utilizes two separate grossprofit percentages which seems toe taking great liberties with thelanguage in the statute.

(2) There is an ambiquity in theService's definition of squalifyingindebtednesss which may causeproblems for real estate developerswho refinance a construction loanwith a permanent, stake outs loan.

(3) The definition of rappedindebtedness. in te regulation isnot clear.

(4) In Hunt v. Commissioner, 80 T.C.1126 (1983), the Tax Court for thefirst time dealt with a purewraparound mortgage (which did notinvolve a de facto assumption ortaking subject to as in Voight andGoodman) and held for the taxpayer.The court held that the Stonecrestline of cases, which involvedconditional sales, also applies towraparound mortgages. The facts ofHunt pre-date the Installment SalesAct and the court specificallyreserved judgment on what impact,if any the Service's TemporaryRegulation would have on itsdecision if it were presentedsimilar facts arising after 1980.

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(5) In Professional EquitiesCorporation v. Commissioner, 89T.C. 165 (1987), the Tax Court heldthat Temp. Reg. $l5A.453-l(b) (21(ii) was invalid and wasinconsistent with the Stonecrestline of cases. The Commissionersubsequently announced acquiescencein the Professional Equitiesdecision. 1988-2 C.B. 1. However,it is important to note that thecourt was not required tospecifically address the issue ofmortgage in excess of basis. Indicta contained in footnote 17 ofits opinion, the court stated thatit seemed reasonable to treatmortgage in excess of basis as apayment in the year of sale. Thiscomment appears inconsistent withthe Stonecrest line of cases andthis issue must be listed asunresolved until a later court isrequired to deal with it.

(6) The Tax Court reaffirmed itsholding in Professional Equities inVincent E. Webb, 54 T.C.M. 443(1987).

C. Installment sales with participation feature.

1. Description of proposal. A third alternativeproposed by Developer provides for thepurchase of the Ta] Mahal Grove for?25,000,000 plus 10% of the sales price, netof sales commissions and other sellingexpenses, derived from all sales of lots orparcels from the property for a period of tenSears after closing (referred to as anEquity Kickerl). However, the aggregate

payments under the Equity Kicker feature arenot to exceed $15 000,000. The $25,000,000fixed portion of the sales price is payableas follows:

$ 5,000,000 Down payment9,000,000 Assumption of original mortgages11,000,000 Purchase money note and mortgage

$25,000,000

The purchase money note and mortgage willcontain the same terms and conditions asunder the first proposal except that theterms of the Equity Kicker will also beincorporated into the note, and interest willbe payable solely with respect to the$11,000 00 principal amount and not on theEquity Kicker.

2. Planning with regard to equity participationfeatures. Property owners, such as the

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Trumpets who sell land to developers arefrequently torn between the desire to engagein an outright sale of their property or toenter into a joint venture with the developerto develop and sell the property and obtain agreater return. In an attempt to obtain thegest of both worlds, some sellers attempt tosell their properties for a fixed pricecoupled with a participation feature equal toa fixed or variable percentage of theproceeds derived by the developer from resaleof the land. There are a number ofvariations of this approach. For example,the participation interest furnished to theTrumpets might have been payable from netprofits (rather than from net salesproceeds); it might have been subject to agreater or lesser ceiling than $15,000 000or, alternatively, to no ceiling at all);and the participation might have phased outover a greater or lesser period of years thanten. The objective of the seller in each ofthese instances is to lock in a guaranteedminimum selling price for his land while atthe same time participating in the upsidepotential from subsequent development of theproperty.

3. Tax issues. Equity participation sales giverise to a number of tax issues including thefollowing:

a. Sale versus partnership (or,alternatively, part sale/partpartnership).

b. If the transaction is recognized as asale for tax purposes, will installmentreporting be available for thecontingent portion of the purchaseprice?

c. If installment reporting is available,how do the original issue discount( ID ) rules of S§1272-1275 apply totMe contingent payments (which, in ourexample, are non-interest bearing)?

d. If installment reporting is available,how does the interest toll charge of§453A(a)(1) apply to the contingentportion of the sales price?

4. Application of installment reporting rules tocontingent price sales. If the sale by theTrumpets for $25,000,000 plus an EquityKicker is recognized as a sale for federalincome tax purposes, the application of theinstallment reporting rules of §453 to thecontingent port ion of the purchase price isgoverned by a special set of rules.

a. Prior to Installment Sales Act, if apurchase price was contingent,

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installment sale reporting was notavailable but the seller was entitled torecover basis against the first proceedsreceived. Gralapp v. Commissioner, 458F.2d 1158 (10th Cir. 1972); In Re Steen,509 F.2d 1398 (9th Cir. 1975). Thedetermination of whether the sellingprice was contingent was to be made asof the end of the taxable year in whichthe closing took place. See, Rev. Rul.76-109, 1976-1 C.B. 125.

b. The Installment Sales Act added §453(j)to the Code which instructs the Treasuryto issue new regulations which amongother things, i. . . shall includeregulations providing for ratable basisrecovery in transactions where the grossprofit or the total contract price (oroth) cannot be readily ascertained.i

§453(j) (2).

(1) This determination is to be made atthe end of the taxable year ofclosing. Temp. Reg. §15A.453-1(c) (1).

(2) If the contract is deemed to have amaximum stated selling price,1 theselling price for purposes of g453will be deemed to be he maximumprice payable if all contingenciesare met. If the price ultimatelypayable is less than this amount,the gross profit ratio will berecomputed. Temp. Reg. S15A.453-l(c)(2)(i) (A).

(3) If the selling price is notdeterminable at the end of thetaxable year of closing (i.e., nomaximum stated selling price) butthe maximum period over whichN ayments may be received iseterminable, the seller's basis(inclusive of selling expenses)must be prorated evenly over themaximum pay-out period. Temp. Reg.S15A.453-i(c)(3)(i). If thepayment in any taxable year is lessthan the basis allocable for thatyear (or if no payments are made insuch year), no loss will be allowedunless such year is the final yearof payment, and the basis allocableto such year will be carriedforward to the next succeedingtaxable year. Id.

(4) If there is neither a maximumstated selling price nor a fixedpay-out period, and if thetransaction qualifies as a sale for

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tax purposes, the seller's basiswill be recovered in equal annualincrements over a period of 15yearsI commencing with the taxableyear in which the closing takesplace. Temp. Reg. S15A.453-1(c) (4). If no payment is receivedin a year, or if the paymentsreceived are less than the basisallocable to such year, no losswill be allowed (unless theremaining debt is determined to beworthless), but basis will becarried over to the next succeedingyear.

(5) In each of these three instancest rovision is made for alternativereatment if the seller canestablish to the satisfaction ofthe Commissioner that the generalrules would substantially andinappropriately defer recovery ofthe seller's basis. See, Temp.Reg. S15A.453-1(c) (7)-.

5. Although interest is payable regularly at arate which exceeds the applicable federalrate with respect to the $11,000,000 fixedprincipal amount of the purchase money note,the absence of an interest payment obligationapplicable to the Equity Kicker will resultin original issue discount (2OID1). See,genera1ly, S§1272 through 1275. Since thepurchase money note is issued for non-publicly traded property (i.e., the Taj MahalGrove), the rules of Reg. S1.1275-4(c) willapply. Under these rules, the non-contingent?ay the obligation for payment of

,000,000 o principal and interest thereonat 10% per annum, payable annually) will beseparated from the contingent payments (i.e.,the Equity Kicker and the purchase moneynote will be treated as two separate debtinstruments for purposes of applying the OIDrules. Reg. §i.1275-4(c)(3).

a. The debt instrument representing thenon-contingent portion of the paymentswill not be deemed to have OID becausethe Nstated redemption price atmaturityl ($11,000,000) does not exceedthe issue price ($11,000,000 -- see,§1274). 273(a).

b. The rules governing the contingentpayments due under the note are found inR. §S1.1275-4(c) (3) and (4). Under

this section, the portion of eachpayment due under the Equity Kicker thatis treated as interest will beincludible in the income of theTrumpets, and will be treated as apayment of interest by Developer, in

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their respective taxable years when theamount of the payent becomes fixed.Reg. §1.1275-4(c) (4) (i).

(1) Each payment under the EquityKicker will be treated asconsisting of: (i) a payment ofprincipal in an amount equal to thepresent value of the payment,determined by discounting suchpayment at the applicable federalrate (determined as of the issuedate) from the date the paymentbecomes fixed to the issue date ofthe note, and (ii) the payment ofinterest in an amount equal to theexcess of the total amount of suchpayment over the amount treated asprincipal under (i) above.

6. Section 453A(a)(1) will impose an interesttoll charge u on he deferred tax liabilityinherent in the purchase money note andmortgage (see, discussion under Part II.A.4.,supra). WTIT the toll charge be levied notonly with respect to the deferred gain on thefixed price portion of the note but also theEquity Kicker? If so, will the Deferred TaxLiability be based upon the maximum statedsales price? Cf. Temp. Reg. S15A.453-l(c)(2) (i) (A).-If the regulations ultimatelytake this approach will the Trumpets be ableto recoup part of the interest payable withrespect to the Equity Kicker if theyultimately receive less than the maximumamount due under the Equity Kicker?Alternatively, will a cumulative toll chargebe levied as payents under the Equity Kickerbecome fixed anrdeterminable?

D. Rolling options.

1. Description of proposal. Developer's fourthalternative proposal is designed to enableDeveloper to ac uire the Taj Mahal Grove in aseries of four rolling options. Under thisapproach, most of the Taj Mahal prove will bedivided into four separate parcels which willbe designated as Option Parcels 1 through 4.The balance of the property will be earmarkedfor development into the golf courses, tenniscenter, marina and park entryway and theprincipal access roads that will service theentire property (the Amenities Propertiess).

Developer will initially pay the Trumpets$1,000,000 as consideration for an option topurchase Option Parcel 1 and the Amenitiesroperties for a total purchase price of$8,000,000, which option will remain open fora period of 18 months. The 18-month periodis designed to enable Developer to pursue andobtain all necessary permits and approvalsfrom federal, state and local governmental

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agencies to develop the property. If theoption is exercised' the $1,000.000 optionmonies will be applied against the purchaseprice for Option Parcel 1 and the AmenitiesProperties. If the option lapses, the monieswill be forfeited. The purchase prices forOption Parcels 2 through 4 will a so beagreed upon in advance as well as the timeand sequence in which such options will beexercisable. The prices will be negotiatedand will take into account the fact that theTrumpets must hold these properties off themarket during the applicable option periodsand that the properties will appreciate invalue both because of inflation and due todevelopment of the contiguous properties.

At the time of exercise of Option Parcels 1through 3, Developer will also be required topay an additional $1,000000 to the Trumpetsas consideration for their remaining options,which monies will also apply against thepurchase prices of such parcels if exercisedor will be forfeited if the options areallowed to lapse. Once an option isexercised the purchase price for such optionparcel will be payable in cash at closing.

This proposal provides Developer with downside protection since it has the ability towalk away from the project at any point intime before fully exercising all of itsoptions and thereby limit its costs to theproperties previously purchased plus anyforfeitable option monies paid for futureoptions. Developer has also been advised byits accountants that any costs associatedwith future options (i.e., options that havenot yet been exercised) need not be reflectedas debts on its balance sheet since there isno obligation for Developer to pay theseamounts until the options are exercised.

Although the Trumpets are called upon toassume an additional degree of economic riskunder this proposal, there are severalaspects of the offer which appeal to them.First, the total purchase price for the TajMahal Grove (consisting of the aggregateprices for Option Parcels 1 through 4together with the Amenities Properties) issignificantly higher. Under the terms ofDeveloper's offer, the Trumpets will be giventhe right to approve all preliminary andfinal land plans as well as overalldevelopment plans since these plans willimpact the value of their remainingproperties if one or more of the options arenot exercised. Further, even if Developerallows one or more options to lapse,presumably the value of any property that theTrumpets will be left with will be enhancedin value by reason of the development of thecontiguous properties. Finally, there are

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some significant tax advantages to theTrumpets inherent in this proposal which willbe discussed below.

2. Tax consequences of proposal.

a. Option monies. Despite the fact thatthe Trumpets will have unrestricted useof the $1,000 000 of option monies fromthe point in time that they receivethem, they will not be taxed on theseamounts until the options to which theyrelate are either exercised or lapse.See, Virainia Iron, Coal & Coke Co. v.Commissioner, 37 BTA 195 (1938), aff'd.,99 F.2d 919 (4th Cir. 1938) € cert.denied, 307 U.S. 630; Kitchin v.Commissioner, 340 F.2d 895 (4th Cir.1965); Koch v. Commissioner, 67 T.C. 71(1976); Hicks v. Commissioner, 37 T.C.M.1540 (1978); and Old Harbor NativeCorporation v. Commissioner, 104 T.C.191 (1995). The reason behind theserulings is that the taxability of thepayments cannot be determined until theoptions either lapse or are exercised.

(1) If an option is exercised and theoption monies are applied againstthe purchase price, the monies willbe treated as having been receivedin a sale or exchange of the optionproperties. §1234(ajil); Reg.§1.1234-1(a). Even if the optionmonies are not ap lied against thepurchase price, e Tax Court inKoch v. Commissioner, 67 T.C. 71(1976) held that the same ruleapplies.

(2) If the option lapses the optionmonies must be reported by theoptionor (the.Trumpets) in itstaxable year in which the lapseoccurred. Prior to September 4,1997 such amounts were treated asordinary income. Reg. §1.1234-1(b); Rev. Rul. 57-40, 1957-1 C.B.266. However, §1234A which wasadded to the Code by the TaxpayerRelief Act of 1997 ( RA '97.) nowprovides that any gain arising froma lapse or other termination of aIrights with respect to propertywhich is a capital asset in thehands of the taxpayer will betreated as gain from the sale of acapital asset. An option willpresumably be treated as a Brightowith respect to property. Query:will this change in character fromordinary to capital undermine therationale of Virainia Iron, Coal &Coke Co., supra?

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b. Installment reporting. If the rollingoption transact ion is properlystructured and constitutes a true seriesof options, the installment saleprovisions, including the interest tollcharges and pledging rules of §453A,should not apply. Moreover, to theextent that any depreciation recapturemay be inherent in the property underS1245 the acceleration of gainattri~utable to this depreciationrecapture under §453(i) would also notapply.

c. Capital gains. Since the Trumpets'property has been held by them forinvestment purposes, all the gain fromthe sale of the property should be taxedas long term capital gains. TheService, however, may argue that aportion of the option prices should berecharacterized as ordinary income onthe grounds that disguised interest isbuilt into these option prices.

(1) The Service has argued that optionpayents are tantamount to interestandashould be taxed as such butthis position was rejected by theTax Court in Koch v. Commissioner,supra.

(2) The original issue discount rulesof S§1271 through 1275 should notapply since a true option contractwould not constitute a debtinstrument3 as defined inS1275(a)l). See, §1274(a). InKoch v. Commissioner, supra, theTax Court found that an optioncontract does not constitute aIebtl (67 T.C. at pp. 82,83), and

is rationale would also seem tonegate the resence of a !debtinstrument.

d. Estate planning opportunities. Therolling option approach of Developeralso presents potential estate planningadvantages to the Trumpets in additionto the income tax advantages discussedabove. For example, if the Trumpets'properties were acquired by Developer ina straight sale (as opposed to a rollingoption approach) the Trumpets wouldreceive an installment note for aportion of the purchase price. Thisinstallment note would be treated asincome in respect of a decedent under§691 upon a subsequent death of eitherof the Trumpets prior to the fullcollection of the note. Thus, thedecedent's estate may be required to payestate taxes on the value of the

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installment note and, most importantly,the decedent's heirs would also inheritthe decedent's income tax liability withrespect to the unpaid balance of theinstallment note. See, §1014(c.However, structuring a transaction as aseries of rolling options can eliminatethe income tax problems that theTrumpets' heirs would otherwise inherit.The properties that are subject tooptions that have not yet been exercisedat the date of death will be included inthe decedent's estate and the valueswill probably be tied, at least in part,to the option prices which may eliminatethe necessity of obtaining expensiveappraisals for estate tax purposes. Thedecedent's heirs would also be entitledto a new 1stepped-up basisi under S1014for the portions of the property subjectto the unexercised options which willenable them to subsequently sell theseproperties if the options are exercisedwithout the necessity of paying incometaxes (because the sales prices will beexactly equal to their tax bases).Caveat: the repeal of the stepped-upbasis in 2010, and the institution ofnew modified carryover basis rules underthe Economic Growth and TaxReconciliation Act of 2001 wouldundermine this planning for decedentswho die in 2010.

III. Exchange of Properties. In their preliminarydiscussions with Developer the Trumpets suggested thatthey might ask Developer to accommodate their taxplanning objectives by structuring all or a portion ofhe acquisition of the Taj Mahal Grove as a like-kindexchange under §1031. An exchange is particularlyappealing to the Trumpets because they will be able toroll all or a substantial portion of their $21,000,000of equity in the Taj Mahal Grove into one or morereplacement properties. By contrast, a sale of theproperty followed by a reinvestment of the after-taxproceeds in replacement property will reduce theTrumpets' equity in such property to approximately$15,400,000.

A. Developer's proposal. After consideration of allof the alternative proposals described in Part Iabove, the Trumpets have informed Developer thatthey are neither willing to defer receipt of theirmonies nor to accept the risks inherent insubordination to an acquisition and developmentloan. After considerable hand-wringing anddiscussions with its bankers, Developer has beenable to raise sufficient financing to purchase theentire Taj Mahal Grove for cash. Accordingly,Developer has informed the Trumpets of itswillingness to purchase the property for$30,000,000, payable by assuming (or refinancing)the existing $9,000,000 of mortgage indebtednesswith the balance payable in cash at closing. The

- 25 -

contract will be subject to a 180-dayinvestigation period in which Developer will beable to satisfy itself with regard to title,zoning, permits, environmental compliance, soiltesting, etc. If, at the end of the 180-dayperiod Developer has not notified the Trumpets ofits intent to terminate the contract (in whichcase it would have no further obligation to theTrumpets other than to provide them with theresults of its investigation), it will beobligated to close on the property within 45 daysthereafter. Developer has agreed to insert anNexchange cooperation claus5 in the contract ofsale setting forth its a reement to cooperate to areasonable extent with the Trumpets in structuringthe disposition of all or a por ion of the TajMahal Grove as a §1031 exchange.

The Trumpets have been advised by their taxattorney and CPA that they may defer recognitionof income on the disposition of the Taj MahalGrove through a §1031 exchange. Under the planproposed by the Trumpets' tax advisors, theTrumpets would enter into an exchange agreementwith Great Clinton Trust and Fidelity ExchangeCorporation which will serve as a qualifiedintermediaryl in connection with te transaction( Qualified-Intermediaryt). The exchangeagreement will require the Trumpets to assign allof their rights under the real estate salesagreement between Developer and the Trumpets tothe Qualified Intermediary and Developer will benotified in writing of the assignment. On theclosing date for the sale of the Taj Mahal Groveto Developer Qualified Intermediary will completethe sale of the Taj Mahal Grove to Developer inaccordance with the terms of the real estate salesagreement. However in order to avoid possibleliabilities from getting in the chain o title andin order to avoid transfer taxes, QualifiedIntermediary will instruct the Trumpets (pursuantto the ri ght to do so contained in the exchangeagreement to direct deed the Taj Mahal Groveproperty to the Developer at closing. Thus, eventhough the rights of the Trumpets under the realestate sales agreement will have been assigned toQualified Intermediar and Qualified Intermediarywill be reflected as he Iselleri of the Taj MahalGrove at closing, the Trumpets will execute a deedconveying the Ta) Mahal Grove directly toDeveloper at closing. The net cash due the sellerwill be paid directly to Qualified Intermediarywho will hold the funds in escrow under the termsof the exchange agreement.

The exchange agreement provides that the Trumpetswill have 45 days after the date of closing on theconveyance of the Taj Mahal Grove to identify oneor more replacement properties. If the Trumpetshave not identified any replacement propertieswithin such 45-day period they will have a rightto withdraw all monies out of the escrow in whichthe Qualified Intermediary was holding such funds.In such a case, the Trumpets understand that the

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transaction will be treated as a fully taxablesale by them and no deferral under 51031 will beavailable. However, if any properties areidentified within the 45-day period, the escrowmonies will be used by the Qualified Intermediaryto purchase replacement properties approved by theTrumpets and any unused funds can be claimed bythe Trumpets only after the Trumpets have receivedall the replacement properties to which they areentitled or upon the expiration of the lexchangeperiod.1 The Nexchange periodo is defined in theexchange agreement to be a period which commenceson the date of closing of the conveyance of theTaj Mahal Grove and which ends on the earlier of:(i) the 180th day after the closing date, or (ii)the due date (including any extensions actuallyobtained) for the Trumpets' federal income taxreturn for the taxable year in which the closingon the transfer of the Taj Mahal Grove took place.

The exchange agreement will permit the Trumpets tolocate suitable replacement properties which wereidentified within the initial 45-day period,contract for the purchase of such properties andassign such contracts to the QualifiedIntermediary with appropriate written notice tothe seller of each such replacement property. TheQualified Intermediary will then acquire each suchreplacement property identified by the Trumpetsusing the funds held by it in escrow and, onceagain, will instruct the seller of the replacementproperty to direct deed the property to theTrumpets.

The exchange agreement also requires the QualifiedIntermediary to segregate all funds obtained by itfrom the sale of the Taj Mahal Grove in a separatebank account and to invest such funds inconservative, interest bearing investments whichare readily convertible to cash on short notice.

B. Tax implications to Trumpets.

1. General rules of §1031. Section 1031(a) l)permits a taxpayer to eliminate recognitionof gain if property held by such taxpayereither for productive use in a trade orbusiness or for investment is exchangedsolely for replacement property of a likekind which will also be held by such taxpayereither for productive use in a trade orbusiness or for investment. Since theTrumpets have held the Taj Mahal Grove(referred to in this section of the outlineas the Brelinquished property,) forinvestment purposes, the exchange of suchproperty for like kind property which will beeld by the Trumpets either for productive

use in a trade or business or for investmentwill qualify for nonrecognition treatmentunder §1031(a) (1).

a. If the Trumpets receive both like kindproperty and cash or other non-like kind

- 27 -

properties in exchange for therelinquished property, the transactionswill not qualify for nonrecognitiontreatment under §1031(a (1) because therelinquished property will not have beenexchanged solely for like kind property.However, §1031(b) provides that if anexchange would otherwise be eligible fortax free exchange treatment but for thepresence of cash or some other form ofnonqualifying propty (Ybootgain realized in the transaction will berecognized for tax purposes but only tothe extent of the sum of the money andthe fair market value of the other bootreceived.

(1) Relief from liabilities eitherthrough assumption of suchliabilities by the other party tothe exchange or by conveyance ofropertyto the other party subjecto an existing mortgage will betreated as a receipt of boot to theextent of the debt assumed or takensubject to. Reg. §l.1031(b)-l(c).Thus, the Trumpets will be deemedto have received at least$9,000,000 of boot attributable toDeveloper's assumption of existingmortgages encumbering theirproperty.

(2) Under certain circumstances, bootreceived by the Trumpets in theform of mortgages assumed or takensubject to may be offset or nettedagainst boot given in the exchangeby the Trumpets in the form of cashtaid or by the assumption of (oraking subject to) mortgagesencumbering the replacementproperty received by the Trumpetsin the exchange. For example, ifthe replacement properties receivedby the Trumpets from Developer areencumbered by mortgages totaling$9 000,000 or more, the Trumpetswill not be deemed to have receivedany net boot in the exchangeattributable to the $9,000,000mortgage debt which they wererelieved of upon transfer of theTaj Mahal Grove.

b. Section 1031(a)(1) requires that boththe relinquished propert and thereplacement property be JheldI by theTrumpets for 1productive use in a tradeor business or for investment.1

(1) The regulations under §1031 do notcontain any guidance regarding useBin a trade or businesso or for

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linvestment.l However, for usefulanalogies see §§167 and 1231regarding -rade or businessproperties and §1221 for investmentproperties.

(a) Property held for productiveuse in a trade or business maybe exchanged for property heldfor investment or vice versa.Reg. §1.1031(a)-l(a). Forexample, the Trumpets mayexchange the relinquishedproperty, which was held bythem for investment, for otherreal property which will beheld by them for productiveuse in a trade or business.

(2) The requirement that both therelinquished property and thereplacement property be Rheldl forone of the requisite purposesraises some potential problems.For example if the Trumpetsreceive qualifying like kindreplacement property in exchangefor the relinquished property butimmediately thereafter sell thereplacement property in a taxabletransaction, the exchange probablywill not be eligible for §1031nonrecognition treatment becausethe replacement property will bedeemed to be held for sale ratherthan for investmenf or forE roductive use in a trade orusiness. See, Black v.Commissioner, 35 T.C. 90 (1960).

(a) The Service has also taken theposition that if propertyreceived in an exchange whichwould otherwise qualify under$1031 is promptly disposed ofin a nontaxable exchange, thereceipt of the replacementproperty will not be eligiblefor §1031 nonrecoqnitionbecause it was not shel forthe required purposes. dee,eq Rev. Rul. 75-292, 1975-2C.B. 333 (property received ina purported §1031 exchangeimmediately transferred to acontrolled corporation under§351 ineligible for §1031nonrecognition treatment).However thus far the courtshave not been very sympatheticto the Commissioner's positionwith regard to tax freedispositions or acquisitionsof properties either preceding

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or following a purported S1031exchange. see, Maqneson v.Commissioner, 81 T.C. 7671983) aff'd. 753 F.2d 1490(9th C-r. 1985); Bolker v.Commissioner, 81 T.C. 7821983), aff'd. 85-1 U.S.T.C.9400(9E-Cir. 1985); Mason

v. Commissioner, 55 T.C.M.1134 (1988); and Maloney v.Commissioner, 93 T.C. 89(1989).

C. Another requirement for nonrecognitiontreatment under §1031(a)(1) is that therelinquished property and thereplacement property must be of Ilikekind.I The regulations adopt a liberalconstruction of like kind for purposesof applying the nonrecognition rubes:

IThe words 'like kind' havereference to the nature orcharacter of the property and notto its grade or quality . . . Thefact that any real estate involvedis improved or unimproved is notmaterial, that fact relates only tothe grade or quality of theproperty and not to its kind orclass.j Reg. S1.1031(a)-1(b).

Based upon this liberal definition oflike kind, the Trumpets may (forexample) exchange the Taj Mahal Grovefor a commercial office building or anapartment complex. Since both thecommercial office building and theapartment complex are real properties,they are deemed to be of Ilike kindawith the Taj Mahal Grove under thedefinitional test of the regulations.

(1) Note that, to the extent that theTrumpets may also receive tangiblepersonal property in connectionwith the apartment complex orcommercial office building inaddition to the real property, thevalue of the tangible personalproperty will constitute boot andwould not be regarded as like kind.It is not real property.

(2) Citrus trees are S1245 property.If any portion of the purchasetrice is allocated by the partieso the citrus trees and like kind

real properties which alsoconstitute S1245 properties andwith a value at least equal to thevalue of the citrus trees are notincluded in the replacementproperties received by the

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Trumpets, §1245(b) (4) will override§1031(a) and force recognition ofthe §1245 recapture income.

d. Section 1031 is a deferral provision.Like most deferral provisions of theCode, it exacts a price fornonrecognition in the form of areduction in basis in the replacementproperty received in a §1031 exchange.Under §1031(d), the Trumpets' tax basisin the replacement property will beequal to he basis of the relinquishedproperty reduced by any cash receivedand any loss recoqnized (which would beattributable to the exchange of bootproperties), and increased by any gainrecognized. For this purpose,liabilities encumbering the relinquishedproperty and the replacement propertywhich are either assumed or takensubject to will be treated as cashreceived or cash paid (respectively) forpurposes of the basis computation rules.SlO031(d).

e. Tacking of holding periods is authorizedunder §1223(1) with respect to thereplacement properties received by theTrumpets in the exchange if both therelinquished property and thereplacement properties are eithercapital assets, as defined in §1221, orproperties described in §1231. Thus,assuming that the Trumpets receivequalifying replacement property thatwill constitute either a capital assetor a §1231 asset in their hands, theywill be eligible to tack on the holdingperiod of the relinquished property tothe replacement property under §1223(1).

2. Multi-party exchanges. The plan conceived bythe Trumpet's tax advisors contemplates morethan a simple barter exchange of propertiesbetween two people. Under this plan, theTrumpets must first locate, negotiate andprobably contract for the acquisition of oneor more replacement properties. Thereafter,any such contract for a replacement propertywill be assigned to Qualified Intermediary(with written notice to the seller of suchproperty) which will then close on thepurchase of the replacement property usingfunds from the qua ified escrow and instructthe seller to direct deed the replacementropert to the Trumpets. This scenario isEut a short step removed from the payment ofcash by Developer to the Trumpets (or to anagent of the Trumpets) followed byreinvestment of the cash in replacementproperties.

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a. Not surprisingly, the latter view wasadopted by the Service when firstconf ronted with multi-party exchanges.Fortunately for taxpayers, the earlydecisions in this area adopted a liberalconstruction of §1031 as it applied tomulti-party exchange situations andestablished a pro-taxpayer trend that,with some judicial deviations, has beenliberalized to an even greater extent inrecent years. See, e.., MercantileTrust Co. of BaltEimore v. Commissioner,32 B.T.A. 82 (1935); J. H. BairdPublishinQ Co. v. Commissioner, 39 T.C.608 (1962); Alderson v. Commissioner317 F.2d 790 (9th Cir. 1963); CoastalTerminals, Inc. v. United States, 320F.2d 333 (4th Cir. 1963) (the precedingcases represent the Nearly line ofcases aplying an expansive applicationof §Si31 to multi-party exchanges);Bicas v. Commissioner 632 F.2d 1171(5th Cir. 1981); Starfker v. UnitedStates, 602 F.2d 1341 (9th Cir. 1979);Barker v. Commissioner 74 T.C. 555(1980); Brauer v. Commissioner, 74 T.C.1134 (1980); Hayden v. United States82-2 U.S.T.C. 19604 (D. Wyom. 1981) andGarcia v. Commissioner, 80 T.C. 491(1983) (the second group of casesrepresent the more recent and, ifanything, more liberal decisionsinvolving multi-party exchanges).

3. Deferred exchange. The exchange planproposed by the Trumpets' tax advisorscontemplates that all of the replacementproperty may be identified and/or acquiredand transferred to the Trumpets after theclosing (i.e., after the transfer of therelinquished property by the Trumpets toDeveloper through the QualifiedIntermediary). This is referred to as aNdeferred exchange.N Deferred exchangespresent several unique tax issues which havegenerated a great deal of controversy betweentaxpayers and the Service.

a. The Tax Reform Act of 1984 0fTRA '84 )added S1031(a)(3) to the Co e whichprovides that any property received in adeferred exchange will be treated asboot unless:

(1) The replacement property must beidentified on or before the 45thday after the taxpayer transfersthe relinquished property, and

(2) The replacement property must beactually received by the taxpayeron or before the earlier of: (i)180 days after the relinquishedproperty is transferred, or (ii)

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the due date (determined withextensions) of the transfe-ror'sreturn for the taxable year inwhich the transfer of therelinquished property occurs.

The addition of §1031(a) (3) to the Codeby TRA '84 was designed to preventpotential abuses which both the Serviceand Congress believed could occur if notime constraints were imposed on closingout deferred exchanges. However, thissection effectively sanctions the use ofdeferred exchanges that otherwisequalify for like kind exchange treatmentunder 1031 and meet the identificationand receipt requirements of §1031(a) (3).

b. On May 1, 1991, final regulations wereissued by Treasury governing deferredexchanges which apply to transfers ofproperty made on or after June 10, 1991(subject to certain rules applicable totransfers made on or after May 16,1990). Reg. §1.1031 k)-1(o). Theseregulations define deferred exchanges,establish operating rules for theidentification and receipt requirementsof §1031(a)(3), create four safe harborsfrom the constructive receipt rules thatwill be unique to deferred exchangesand, finally, provide additionalguidance for the computation of gain orloss to be recognized as well as basiscomputations in deferred exchanges.

c. Assuming that all or a substantialportion of the replacement propertiesare not received by the Trumpets priorto closing, what impact will thedeferred exchange regulations have uponthe transactions contemplated byDeveloper's proposal to the Trumpets?

(1) First, the Trumpets must identifyoone or more like kind repiacementproperties before the expiration ofhe identification period.

(a) The identification periodbegins on the date theTrumpets transfer therelinquished property toDeveloper (through theQualified Intermediary) andends 45 days'thereafter. Reg.S1.1031(k)-l(b)(2). Forpurposes of determining thegate on which theidentification period ends,§7503 (relating to the timefor performance of acts wherethe last day falls on aSaturday, Sunday or legal

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holiday) does not apply.. Reg.§i.1031(k)-1(c)T Thus, if the45th day after the Trumpetstransfer the relin uishedproperty falls on December 25or January 1, theidentification periodnevertheless enas on thatdate.

(b) In order to midentifyoreplacement property theTrumpets must either (i)designate the replacementproperty in a written documentsigned by them and hand-delivered, mailed, telecopiedor otherwise sent before theexpiration of theidentification period toQualified Intermediary or (ii)execute a written agreementwith Qualified Intermediarywhich meets all of the above-described identificationrequirements and which issigned by all parties to thetransaction. Reg. Si. 1031(k)-1(c)(21. Notwithstanding theforegoing, any replacementproperty actually received byhe Trumpets before theexpiration of theidentification period will inall events be treated as if ithad been identified. Reg.S1.1031(k)-1(c) (1).

(c) The Trumpets mustOnambiguously describe4 thereplacement property in-thewritten document or agreement.Reg. S1.1031(k)-1(c)(3).Since the replacement propertywill be a real estate parcel,it must be described either byutilizing its full legaldescription or a streetaddress. Id.

(d) In view of the size and valueof the Taj Mahal Grove, it isunlikely that the Trumpetswill be able to find a singlereplacement property forQualified Intermediary toacquire and transfer to them.The proposed regulations willenable the Trumpets todesignate alternative and/ormultiple properties within theidentification period. Reg.§1. 1031 (k) -1 (c) (4). Theproposed regulations provide

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that the maximum number ofreplacement properties thatthe Trumpets may identify iseither (1) three propertieswithout regard to the fairmarket values of suchproperties (the 13-propertyrul4) or (ii) any number ofproperties provided that theaggregate fair market value atthe end of the identification]eeriod of all such propertiesoes not exceed 200% o the

fair market value of therelinquished propertydetermined as of the date therelinquished property istransferred b the Trumpets(the 1200% ruleq). A warningis contained in e7 . tt§1.1031(k)-ljc)(4)ii that ifat the end o heidentification period theTrumpets have identified moreproperty than is permittedunder the alterna ive rulesdescribed above, they will betreated as if they had failedto identify any property undersuch rules (subject to twolimited savings provisions).

i) The Trumpets are giventhe opportunity to steerclear of the rather harshpenalties for failing tomeet either the 3-property rule or the 200%rule through the use ofthe revocation rulescontained in Req.§1.1031(k)-i c)(6). Thisprovision enables therumpets to terminate thedesignation of anyparticular replacementproperty prior to the endof the identificationperiod in the same manneras such property wasoriginally identified.It should be noted thatan oral revocation willnot be effective. Reg.§1.1031(k)-l(c) (6) and(7), Ex'7.

(2) Secondly, §1031(a) (3) (B) providesthat the replacement property whichhas been properly identified inaccordance with the requirementsset forth above must also bereceived by the Trumpets within theexchange period. The receipt

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requirements are explained andamplified in Reg. §§1.1031(k)-i(b)and (d). Reg. §1.1031(k)-l 01)states that any property which isnot received wit hin the exchangeperiod will be treated as boot.

(a) The Nexchange periods isdefined in Reg. 19 I31(k)71(b)(2) as a period beginningon the first date the Trumpetstransfer the relinquishedproperty and ending on theearlier of 180 days thereafteror the due date (includingextensions) for their taxreturn for 2001 (i.e., theyear in which the transfer ofhe relinquished property took

place), The rules fordetermining the commencementdate of the exchange period aswell as of the date ofexpiration are identical tothose applicable to theidentification period.

(b) The Trumpets will only bedeemed to have receivedreplacement property withinthe exchange period if (i)they receive the replacementproperty before the end of theexchange period, and (ii) thereplacement property is sub-stantially the same propertyas identified. Reg.§1.1031(kI-l(d). The use ofthe termsubstantially thesame incorporates a degree oftolerance for a minor changein circumstances. See .Req. Sl.1031(k)-l(dT-2 Exs.3and 4.

(3) One of the principal problems con-fronting taxpayers such as theTrumpets who enter into deferredexchange transactions is how tosecure performance by the otherparty under its obligation toacquire and transfer replacementproperties in accordance with theagreement. The planproposed bythe Trumpets' tax advisors dealswith this issue by placing anymonies that were not expended toacquire replacement property at thetime of closing in an escrow fundwith Qualified Intermediary. Theplacement of cash in an escrow hascaused many practitioners to worrythat the taxpayer would be deemedto have constructively received the

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cash. [In addition, QualifiedIntermediary may be deemed to bemerely an agent of the Trumpets.This issue will be discussedbelow.] In the installment salearea, the Service has successfullyasserted that securing aninstallment obligation with cashresulted in constructive receipt.See, Oden v. Commissioner. 56 T.C.569 (1971); Pozzi v. Commissioner,49 T.C. 119 (1967); and Rev. Rul.79-91, 1979-1 C.B. 179. Moreover,the temporary regulations under§453 reinforce this concept.Temp. Reg. §15A.453-1(b)(3 (ii-.However, in Garcia v. Commissioner,80 T.C. 491 (1983), funds placed inescrow to secure a deferredexchange and which were subject tosubstantial restrictions whichprevented the taxpayer from gainingaccess to the funds except in theevent of a default resulted in aruling in favor of the taxpayer onthe issue of constructive receipt.However, see, Maxwell v. UnitedStates, 88-2 U.S.T.C. 9560 (S.D.Fla. 1988) which resulted in aholding in favor of the Servicebecause the taxpayer had failed toprovide a Nbulletproof escrow.1

(a) The deferred exchangeregulations establish a safeharbor from the constructivereceipt rules if theobligation of QualifiedIntermediary to purchase andtransfer replacementproperties is secured by cashor a cash equivalent held in a

ualified escrow account.eg. §l.1031(k)-l(g)(3).

qualified escrow account isone in which the escrow holderis neither the taxpayer nor a

isqualified persons (asefined in Reg. §1.1031(k)-1(k)) and in which thetaxpayer's rights to receive,pledge, borrow or otherwiseobtain the benefits of thecash or cash equivalent heldin escrow are limited to thefollowing circumstances:

i) The taxpayer may withdrawthe cash if he has notidentified replacementproperty within theidentification period butsuch withdrawal may onlytake place after the

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expiration of theidentification period.

ii) The taxpayer may withdrawany remaining cash heldin escrow after he hasreceived all of theidentified replacementpropert to which he isentil±e .

iii) If the taxpayer hasidentified qualifiedreplacement property buthas conditioned thereceipt of such propertyupon a material andsubstantial contingencythat relates to thedeferred exchange, thatis provided for inwriting and that isbeyond the control ofboth the taxpayer and anyrelated party, and ifsuch material contingencyis not satisfied, thenthe taxpayer may receivecash from the escrow (butnot prior to the end ofthe identificationperiod).

iv) The taxpayer may receiveany cash remaining inescrow after the end ofthe exchange period.

Reg. §l.1031(k)-l(g) (6).

Thus, if the Trumpets wish totake advantage of the safeharbor, they must be certainthat the terms of the escrowcomply with the conditionsoutlined above.

(b) It is important to note (andfrequently overlooked) thatthe qualified escrow isintended as a passive vehicleto secure the buyer'sperformance of its obligationsto acquire and conveyreplacement property to thetaxpayer. If the escrow agentassumes a more active role,such as contracting topurchase replacement propertyand convey it to the taxpayer,the escrow agent must alsoqualify as a lqualifiedintermediary as described in(4) infra.

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(c) The Trumpets will betransferring the relinquishedproperty when it is encumberedbymortgages totaling$91000,000 which will beassumed by Developer. Asnoted in the discussion above,the assumption of indebtednessencumbering the relinquishedproperty constitutes boot tohe Trumpets unless it isnetted against either cashpaid by the Trumpets ormortgages on replacementproperties that are assumed ortaken sub ject to by them.Suppose that the transfer ofthe relinquished property bythe Trumpets takes place in2001 but the receipt ofreplacement properties doesnot occur until 2002. Can thedetermination of whether therelief from $9,000 000 ofliabilities constitutes bootbe postponed until thereplacement properties arereceived (at which time itcould be determined whetherthe Trumpets are entitled tonet any liabilities assumed ortaken subject to or whetherthey will be required to paycash)? This question is notanswered directly in theproposed regulations but Reg.51 1031(k)-l(j) Ex.5contemplates that deferrednetting of mortgages will beallowed.

(d) The proposed plan toaccomplish a Ml031 exchange ofthe Taj Mahal Grovecontemplates that QualifiedIntermediary need not acquiretitle to replacement propertyin its name. QualifiedIntermediary may refuse toappear in the chain of titlefor fear that it might incurpotential liability forenvironmental cleanupproblems. It is now clearthat both the relinquishedproperty and any replacementproperties may be directdeeded for bona fide non-taxreasons such as enabling thepurchaser or intermediary toavoid being in the chain oftitle. See, Reg. §S1.1031(k)-lg ) (4) (iv) (B) and 1.1031(k)-I g (4 v) in which direct

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deeding using the qualifiedintermediary safe harbor isspecifically sanctioned. See,also, Rev. Rul. 90-34, I.R.B.1990-16 (4/16/90); W. D. HadenCo. v. Commissioner, 165 F.2d588 (5th Cir. 1948); Biqqs v.Commissioner; 632 F.2d 1171(5th Cir. 1981); Brauer v.Commissioner, 74 T.C. 1134(1;980);and Rutland v.Commissioner, 36 T.C.M. 40(1977).

(4) More often than not a prospectivebuyer will refuse to be an activeparticipant in accomplishing a tax-free exchange for the taxpayer. Inother words, the purchasergenerally has little if anyinterest in becoming involved inacquiring replacement property onbehalf of the taxpayer. In suchcases, taxpayers are frequentlytempted to use an intermediary toaccomplish the sale of therelinquished property while at thesame time facilitating a deferredexchange under §1031. Theintermediary will typically enterinto an exchange agreement with thetaxpayer pursuant to which thetaxpayer will convey its propertyto the intermediary (or will directdeed to the ultimate purchaser whenthe intermediary closes on the saleof the relinquished property) inexchange f or the intermediary'sagreement to acquire and conveyreplacement property to thetaxpayer. The principal tax riskassociated with this technique wasthat the intermediary would befound to be the taxpayer's agentand that, as a consequence, thereceipt or money or other non-likekind property by an intermediarywould be treated as having beenreceived by the taxpayer.

The deferred exchange regulationsnow offer a very generous safeharbor for the use of a sualifiedintermediaryj to facilitate anexchange witd the promise that, ifcomplied with, the intermediarywill not be treated as thetaxpayer's agent for tax purposesand the taxpayer will not betreated as being in actual orconstructive receipt of money orother non-like kind pronerty heldby the intermediary. Reg.§1.1031(k)-1(g) (4) i). The

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Trumpets' tax advisors have reliedupon this safe harbor instructuring their proposed plan toaccomplish a §1031 exchange.

(a) A ualified intermediary isdemned in Reg. 1l.1031(kf-l(g) (4) (iii) as '. .person who (A) is not ataxpayer or a disqualifiederson [as defined in Rey.

.1031 k)-1(k)], and (B)enters into a writtenagreement with the taxpayer(the lexchange agreemento)and, as required by theexchange agreement, acquiresthe relinquished property fromthe taxpayer, transfers therelinquished property,acquires the replacementproperty, and transfers thereplacement property to thetaxpayer.1

(b) The exchange agreement that isrequired to be entered into bythe taxpayer and theintermediary must include thefollowing:

(i) The agreement mustrequire that theintermediary acquire therelinquishea propertyfrom the taxpayer,transfer the relinquishedproperty, acquire thereplacement property andtransfer the replacementproperty to the taxpayer.Reg.l.T031(k)-1(g) (4) (iii) (t) ; and

(ii) Restrict the taxpayer'sright to receive, pledge,borrow, or otherwiseobtain the benefits ofmoney or other propertyheld by the intermediaryto the extent required inReg. §1.1031(k) -(g)(6).Reg. §1.1031(k)-1l(g; (4) (i i) .

(c) Direct deeding is specificallysanctioned in the finalregulations in connection withthe qualified intermediarysafe harbor. Although thequalified intermediary isrequired to both acquire andconvey the relinquishedproperty, Reg. §1.1031(k)-

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1(g) (4) (iv) (B) provides thatan intermediary will betreated as acquiring andtransferring the relinquishedproperty if the intermediaryenters into an agreement witha person other than thetaxpayer for the transfer ofthe relinquished property tothat person and, pursuant tothat agreement, therelinquished property istransferred to that person(i.e., direct deeded from thetaxpayer to the ultimatepurchaser). It should benoted that direct deeding issanctioned only if theintermediary-rsE establishescontractual privity with thepurchaser of the relinquishedroperty. However, Reg.1.1031(k)-l(g) (4) (v) also

authorizes the taxpayer toenter into a contract for theconveyance of the property andspeci ically assign thatcontract to the intermediary(which presumably may becoupled with the directdeeding) provided that allparties to the agre-ement arenotified in writing of theassignment on or before thedate of the relevant transferof property. Similar rulesare also provided with respectto direct deeding inconnection with theacquisition of the replacementproperty by the qualifiedintermediary and ultimateconveyance by it to thetaxpayer. See, Reg.S1.10M1k -1 (g) 4) (iv) (C) .Direct deeding is almostessential because of concernsregarding compliance withenvironmental laws and thepossible exposure that theintermediary might face if itwere included in the chain oftitle.

(d) The proposed §1031 exchangeplan developed by theTrumpets' advisorscontemplates the use of thequalified intermediary safeharbor in conjunction with aqualified escrow in order tobetter secure performance bythe intermediary and protect,to the extent possible, the

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monies and other propertiesheld by or for theintermediary from the claimsof the intermediary'screditors, including thebankruptcy trustee. Thistandem use of these safeharbors is specificallysanctioned in Reg 1031(k)-l(g)(1) provided that all ofthe terms and condition-sofeach safe harbor areseparately satisfied.

(5) The exchange agreement that theTrumpets' tax advisors haveproposed contemplates that anymonies held by the QualifiedIntermediary pending acquisition ofreplacement properties will beplaced in interest bearinginvestments. Consequently, anysuch interest will be added to theamount held by the QualifiedIntermediary until the replacementSroperties are acquired. Reg.1.1031(k)-1(g)(5) provides that

the right of a taxpayer to receiveinterest or a growth factor withrespect to a deferred exchange willnot, in and of itself, cause thetaxpayer to be deemed to haveactually or constructively receivedboot. Prior to the conclusion ofthis safe harbor in theregulations, a number ofpractitioners questioned whetherthe taxpayer could receive interestearned on funds held by anintermediary and generallysuggested that all such fundsshould belong to, and be retainedby, the intermediary in order toavoid having the intermediarytreated as the taxpayer's agent.

Just as in the case of the othersafe harbors provided in thedeferred exchange regulations, theinterest or growth factor safeharbor will not apply unless thetaxpayer's right to receive theinterest or growth factor islimited to circumstances describedin Reg. §l.1031(k)-l(g) (6).

(i) Any interest earned while thefunds are held by theQualified Intermediary will betreated as interest,regardless of whether theTrumpets ultimately receivethis interest in the form of

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like-kind property or in cash.Reg. §l.1031(k)-l(h) (2).

(ii) The deferred exchangeregulations do not address whois to be taxed on the incomeheld in the qualified escrowor with a qualifiedintermediary. Section468(B)(g) provides thatnothing in any provision ofthe law will be construed asproviding that an escrowaccount, settlement fund orsimilar fund is not subject tocurrent income taxation. TheTreasury has deferredpromulgating rules on thetaxation of earnings within aqualified escrow untilregulations under §468(B) (g)are published. See, reambleto T.D. 8346. Thus, there isstill some question as whosetaxpayer identification numbershould be used when an escrowagent invests funds held in aqualified escrow or qualifiedtrust.

IV. Partnership Proposal.

A. Description of proposal. Developer's thirdalternative proposal to the Trumpets contemplatesthe formation ol a limited partnership to developand market the Taj Mahal Grove. The generalpartners in this partnership will consist ofDeveloper and a new limited liability company tobe formed by the Trumpets. The limited partnerwill be the world renowned professional golfer ,Tiger Nicklaus. Although Nicklaus has built hisreputation by dominating the professional tour forthe past decade, he has also recently developed areputation as an outstanding golf coursearchitect. Nicklaus has agreed to design both ofthe championship golf courses for the project inexchange for his normal fees for design services.However the has also agreed to promote the projectand be Its chief spokesman throughout the UnitedStates and the world for a period of ten years inexchange for a limited partnership interest whichwill provide him with a special interest inpartnership profits described below.

1. Trumpets' partnership interest. Developer'splan calls for the Trumpets to firstcontribute the Taj Mahal Grove subject to theOriginal Mortgages to a newly formed limitedliability company ( TLL in exchange formembership interests inTLLC. TLLC will thencontribute the property to a newly formedlimited partnership consisting of TLLC andDeveloper as general partners and Tiger

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Nicklaus as the limited partner. Thepartnership will assume the OriginalMortgages. TLLC will be given credit for acapital contribution in the amount of$21,000,000 representing the $30,000,000gross fair market value of the Taj MahalGrove reduced by the $9,000 000 outstandingbalance of the Original Mortgages. TLLC willbe responsible for 50% of all partnershipindebtedness including the OriginalMortgages. Although TLLC will not be themanaging general partner of the partnership,Developer would like to utilize Donald andNervanna Trumpets' contacts in the Orlandocommunity, where the Trumpets have been veryactive in local political and communityaffairs. In addition, although the Trumpetshave not been involved in any real estatedevelopment projects, Developer has beenimpressed with their knowledge of real estatein general and wishes to utilize them fromtime to time as consultants in thedevelopment and marketing of the project.Finally, as a general partner in thegartnership, ail major policy decisions muste approved by both Developer and TLLC as

well as all development and marketing plans.

2. Developer's partnership interest. Developerwill contribute $4,000,000 in cash to thelimited partnership in exchange for itspartners hip interest and will also assumeresponsibility for 50% of all partnershipindebtedness. As managing general partner ofthe partnership, Developer will be initiallyresponsible for obtaining all financingnecessary to develop the property, for thepreparation of a development plan, forobtaining all requisite zoning permitsnecessary for the development of the TajMahal Grove in accordance with thedevelopment plan and finally, for themanagement and marketing of the propertyafter development. Developer will beentitled to a reasonable management fee forits services commencing upon completion ofthe first phase of development together witha sales fee equal to 6% of all proceeds fromthe sale of lots townhomes, and industrialsites, and a rental fee of 6% of all rentscollected from the lease of space in theshopping center.

3. Tiger Nicklaus' partnership interest. TigerNicklaus will not be required to make acapital contribution in exchange for hislimited partnership interest. Theconsideration for his partnership interestwill be the rendering of future services overa ten-year period which services are setforth in a separate promotional agreemententered into with the limited partnership.Nicklaus' right to this profits interest willat times during the initial ten-year period

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of the partnership be contingent upon thefulfillment of his contractual obligations topromote the project.

4. Capital accounts, profits, losses and cashflow. Since the partnership agreement willcontain numerous special allocations ofprofits and losses which will not be inaccordance with the capital interests of thepartners, the partnership's tax attorneys andCPAs have insisted that the partnershipagreement be structured to comply with theTreasury regulations promulgated under§704(b). The first step in this process isthe maintenance of capital accounts inaccordance with Reg. S1.704-1(b) (2) (iv). Themaintenance of capital accounts in accordancewith this regulation will effectively requirethe partnership to maintain two sets of books-- one for book purposes which reflects theTaj Mahal Grove at a book-basis of$30 000,000, and a second set of books whichwill be maintained for tax purposes and whichwill reflect the Taj Mahal trove at its taxbasis of $10,000,000.

Subject to the special tax allocationsdescribed in the following paragraph, profitsfrom operations will be a located equally toDeveloper and TLLC until the partnership hasgenerated net profits for book purposes of92,500 000 per annum, determined on acumulative basis since the inception of thepartnership. Any operating profits in excessof this amount will be allocated 45% toDeveloper, 45% to TLLC and 10% to TigerNicklaus. Profits derived from major capitalevents (i.e. profits derived from a sale ofall or a portion of the partnership's realproperties other than the ordinary course ofbusiness or in liquidation of the partnershipor upon a condemnation of more than a minoramount of the partnership's real properties)will be allocated first to partners withnegative capital accounts until such capitalaccounts have been restored to zero; .secondlyto the partners in proportion to theirunrecovered capital contributions until thecapital accounts have been restored to thelevel of their unrecovered capitalcontributions; thirdly, to Developer and TLLCuntil they have received allocations of netprofits from all sources equal to theirpreferential $2,500,000 per year cumulativereturn; and finally, any remaining netprofits will be allocated 45% to Developer,45% to TLLC and 10% to Tiger Nicklaus.Losses from any source will be allocated 50%to TLLC and 50% to Developer. Under nocircumstances are any losses to be allocatedto Tiger Nicklaus.

The Taj Mahal Grove contributed to thepartnership by TLLC will have a built-in gain

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of $20,000,000 ($30,000,000 fair market valueless $10 000,000 tax basis). The partnershipagreement requires that this excess beaccounted for in accordance with therequirements of §704(c) of the Code. Thusfor example, if the entire prop erty was soldon December 31, 2001, for $35,0O0,000, andthe partnership's tax basis in the propertyhad not changed, the first $20,000,000 oftaxable gain must be allocated solely toTLLC. T e remaining $5,000,000 of taxablegain would be allocated among all of thepartners in accordance with the allocationsapplicable to major capital events describedabove.

All positive cash flow generated from generaloperations by the partnership will bedistributed solely to Developer and TLLCuntil they have received total distributionsaggregating 2,500 000 per year, determinedon a cumulative but not compounded basis.Thereafter, any excess net cash flow will bedistributed 90 to Developer and TLLC and 10%to Tiger Nicklaus. Distributions of net cashflow to Developer and TLLC will be dividedbetween them on the basis of 70% to TLLC and30% to Developer until their capital accountshave been equalized and thereafter net cashflow distributed to them will be on an equalbasis.

Upon liquidation of the limited partnershipor upon liquidation of any partner's interestin the partnership any distributions arerequired in all cases to be made inaccordance with positive capital accountbalances of the partners subject to the rulesof Reg. §1.704-1(b)(21(ii)(b) (2). If anypartner (other than Nicklaus) has a deficitbalance in its capital account following theliquidation of such interest, that partner isunconditionally obligated to restore theamount of such deficit balance to theartnership by the end of the taxable year ofiquidation (or, if later, within 90 days

after the date of such liquidation) inaccordance with Reg. S1.704-1 (b) (2) (ii) (b) (3).

5. Financing commitment. Developer has informedthe Trumpets that it has received a bindingcommitment to provide full developmentfinancing for the entire project and torefinance the Original Mortgages. The termsof the development loan include interest attwo points over prime; interest only for aperiod of two years and thereafter principaland interest to be amortized on the basis ofa 25-year mortgage with a balloon at the endof ten years; reasonable release prices forsingle family lots, townhome lots andindustrial sites based upon proj ected resalevalues; and other usual and customary

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development loan provisions. The loan willbe full recourse to the partnership but theTrumpets will not be required to personallyguarantee the loan. Tiger Nicklaus, as alimited partner in the partnership with nodeficit capital account restorationobligations, will also not be required toguarantee the loan.

6. Economic advantages and disadvantages to theTrumpets. The Trumpets will be attracted tothis proposal if they believe that 50% of theprofits in the partnership (45% above thepreferential level) will generate asubstantially greater return than an outrightsale of the property. On the negative side,the income generated from this proposal willbe ordinary income. Furthermore while theTrumpets may enjoy greater opportunities forprofits under the partnership proposal, theywill also bear a greater risk that theproject may fail or may generate less profitsthan expected.

7. Economic advantages and disadvantages to theDeveloper. There are also pluses and minusesassociated with the partnership proposal fromDeveloper's viewpoint. The obvious advantageof this proposal as contrasted with the otheralternatives is that Developer will not berequired to make any investment in theinitial acquisition of the land. Thus, itcan both acguire and develop the propertywith capitai supplied by TLLC and thedevelopment lender. The drawback to thisproposal from Developer's perspective is thatit must now deal with a partner (rather thanhave complete control of the project) and itmust also relinquish 50% (55% above thereferential level) of the potential profits

derived from the venture.

B. Tax consequences to the Trumpets and TLLC.

1. Choice of entity. The Trumpets were advisedby their attorney that TLLC should be formedto participate in the development activitiesin order to limit their liabilities. Theirattorney noted that they are already risking$21 000 000 of equity in the project and theycertainly would not want to risk anythingmore. In addition since the developmentnartnership will clearly be engaged inIdealer activities,1 the Trumpets' attorneyindicated that the use of a separate entitysuch as a limited liability company shouldalso protect the Trumpets from the taint ofbeing engaged (in their individualcapacities) in such activities.

The Trumpets have also been advised by theiraccountant that TLLC will be treated for taxpurposes as a partnership (unless therumpets elect to have it taxed as a

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corporation, which they will not do). Reg.§301.7701-3. He explained that as apartnership, all of the corporation's incomeand losses will pass through to the Trumpetsas its sole members (subject to certainlimitations set forth in Subchapter K of theCode). Since the Trumpets have no interestin retaining the profits from this venture inTLLC, the use of a limited liability companywhich is taxed as a partnership willfacilitate the distribution of their share ofthe profits without incurring a double tax.In aadition, the accountant noted thatDeveloper's projections reflected smallstart-up losses for the first two years ofoperations. Fifty percent of these losseswill pass through to the Trumpets as the solemembers of TLLC and (subject to certainlimitations noted below) may be used by themagainst their income from other sources.

2. Limitations on utilization of losses. One ofthe inducements to the Trumpets to utilize alimited liability company which is treated asa partnership for tax purposes is the abilitto utilize losses from TLLC on their personaForm 1040. However, their tax advisors havecautioned them that these losses are subjectto three primary limitations.

a. First, the source of any losses that mayultimately flow through to the Trumpetsis the partnership. Although mostexpenditures incurred in the conduct ofa development business must becapitalized into the costs of lots andimprovements, it is still possible togenerate taxable losses. Lossesincurred by a partnership will passthrough to its partners in accordancewith their respective distributiveshares. §702(a). However, §704(d)provides that a partner's distributiveshare of losses or a taxable year willbe allowed only to the extent of suchpartner's adjusted basis in itspartnership interest determined as ofhe end of such taxable year. A

partner's basis in its partnershipinterest initially consists of theamount of money plus the adjusted basisof any property contributed by it to thepartnership (§722), and is thereafteradjusted upward for its distributiveshare of partnership profits plusadditional contributions, and decreasedfor its distributive share of thepartnership's losses and for anyistributions made by the partnership to

such partner. S§705 and 722. Mostimportantly, a partner's basis in itspartnership interest is also increasedor its share of the liabilities of the

partnership and for any partnership

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liabilities assumed by it. §752(a).Conversely any reduction in suchpartner's share of liabilities willcorrespondingly reduce such partner'sbasis in its partnership interest.§752(b). Losses in excess of apartner's tax basis in its interest willbe carried forward to future taxableyears until the partner's basis hasincreased sufficiently to facilitate thepass through of the loss. §704(d).

b. Secondly, TLLC's distributive share ofthe partnership's losses will flowthrough to the Trumpets in accordancewith their distributive shares of lossesof TLLC. Since TLLC will be treated as apartnership for federal income taxpurposes, the same rules and limitationsiscussed in IV.B.2.a, supra will apply.

Moreover due to a recent change inFlorida law, TLLC will also be treatedas a partnership for Florida taxpurposes and will, thus, not be subjecto lorida income taxes.

c. Finally, any losses which escape thefirst two layers of limitations will besubjected to a third level oflimitations applicable to passiveactivity losses under §469. [Note: theloss limitation rules of S§704(d) areapplied before the passive activity losslimitationsof S469. See, Reg. §1.469-2T(d) (6).]

(1) The first step in testing lossesflowing from TLLC to the Trumpetsunder §469 is to identify theactivity or activities whichgenerated these losses. Since theshopping center will constitute a

ental undertakinc (and assumingtat the gross income from theshopping center will exceed 20% ofthe gross income of the entireproject so it will not be deemed tobe an incidental operation -- see,Reg. S1.469-4(d) (i), the shoppingcenter must be segreg ated andtreated as an activity separate andapart from the development andsales operations which will also betreated as a single separateactivity. Reg. §1.469-4(c. (Itis assumed that the operation ofthe tennis facilities golfcourses, and marina will likely betreated as incidental to, and apart of, the development and saleactivity.)

(2) Any losses attributable to theshopping center activity, which is

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a rental activity, willautomatically be classified aspassive activity losses, regardlessof the amount of time the Trumpetsparticipate in the activity.469(c) (2) and (4). (It should be

noted, however, that if theTrumpets can satisfy therequirements of §469(c) (7), whichwould require the Trumpets todemonstrate a high degree ofpersonal involvement (involving theperformance of personal services)in the real estate business, theshopping center activity could betested under §469 as a regulartrade or business (i.e., requiringa demonstration of materialparticipation). However, it wille assumed here that the rigorousrequirements of §469(c) (7) cannotbe met by the Trumpets.] Thus, anysuch losses may only be deducted bythe Trumpets against their passiveincome (if anyy, with any losses inexcess of passive income to besuspended and carried forward tofuture years. §§469(a)(1), (b),and (d)(1).

(3) Losses attributable to thedevelopment and sales activity willbe deemed to be attributable to atrade or business activity. If theTrumpets materially participate insuch activity in the taxable yearin question, such losses will betreated as active losses and willnot be subject to the limitationsof §469(a). See, §469(c) (1).Material participation meansinvolvement by a taxpayer in theactivity which is regularcontinuous and substantial.§469(h)(1). The regulations under§469 interpret this section torequire satisfaction of any one ofseveral alternative criteria. See,Reg. Sl.469-5T(a). The principaltest applicable to the Trumpetsrequires them to participate in thedevelopment and sales activity tothe extent of 500 hours during thetaxable year. Reg. §1.469-5T(a)(1). For this purpose, thehours of participation of Donaldand Nervanna Trumpet will beaggregated. §469(h)(5). If the500-hour threshold is met, thelosses attributable to such tradeor business activity may be claimedby the Trumpets without limitationunder §469.

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3. Tax consequences to Trumpets and TLLCattendant to formation of TLLC. No gain willbe recognized by the Trumpets or TLLC uponconveyance of the Taj Mahal Grove to TLLC.§721(a).

a. The assumption of the $9,000,000mortgage by TLLC upon contribution ofthe Ta) Mahal Grove by the Trumpets willnot generate taxable income to theTrumpets. See discussion underIV.B.4.a.(1), infra.

The basis of property received by TLLC is thesame as it was in the hands of the Trumpets.§723. The basis of the membership interestsreceived by the Trumpets will be the same asthe basis of the property transferred($10,000,000), reduced by the $9,000,000mortgage balance assumed by the corporationor a net basis of $1,000,000. §722.

4. Tax consequences to TLLC on formation ofpartnership.

a. No gain will be recognized by TLLC uponconveyance of the Ta] Mahal Grove to thepartnership. S721(a).

(1) The assumption of $9,000,000 of existingmortgage debt will not result in ataxable gain to TLLC. The contributionof property to a partnership which issub~ect to indebtedness which thepartnership either assumes or takessubject to will yield the followingresults to the contributing partner:

(a) The contributing partner willincrease the basis in itspartnership interest by an amountequal to the adjusted basis of theproperty. §722.

(b) The contributing partner will alsoincrease the basis in its partner-ship interest for its share of thepartnership's debt. §S752(a) and722.

(c) Finally, the contributing partnerwill decrease its basis by theentire amount of the debt.S752 (b).

The increase in basis under §752(a)above is treated as a contribution ofcash by the contributing partner to thepartnership. S752(a). Conversely thedecrease in basis attributable to ltherelief from liability referred to abovewill be treated as a distribution ofcash by the partnership to the partner.S752(b). Distributions of cash by a

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partnership to a partner (includingconstructive distributions under§752(bl) will not result in anyrecognized gain to a recipient partnerexcept to the extent that they exceedthe basis in its partnership interest.$731(a)(1). The recipient's basis inits partnership interest will bedecreased (but not below zero) by suchdistribution. SS705(a)(2) and 733(1).If the money distributed and/or deemedto be distributed exceeds basis, suchexcess will be deemed to have beenreceived in connection with the sale ofthe recipient partner's partnershipinterest. §73 1(a).

(2) TLLC's share of the existing mortgagesassumed by the partnership will bedetermined in accordance with Reg.S§1.752-1 and 2. Since the debtconsists of recourse liabilities asdefined in Reg. §1.752-1(a) (1), eachpartner's share of such liability willbe equal to the portion thereof forwhich such partner bears the economicrisk of loss as determined under Reg.§1.752-2 (a).

(a) As a general rule, a partner willbe deemed to bear the economic riskof loss for a recourse debt to theextent that such partner would beobligated to make a payment to thecreditor or a contribution to thepartnership with respect to suchebt (and would not be entitled to

be reimbursed for such payment orsuch contribution) if all of thepartnership's liabilities were dueand payable in full, all of thepartnership's assets (includingmoney) were worthless, thepartnership disposed of all of itsassets in a fully taxabletransaction for no considerationother than the relief ofliabilities and the partnershipallocated all items o income,gain, loss, deduction and creditamong the partners and liquidatedthe partners' interests in thepartnership. Reg. S1.752-2(b) (1).

(b) Applying this test to the facts athand, TLLC's share of the existingmortgage indebtedness will be 50%.

i) It is possible the Servicemight argue that, by virtue ofthe creation of TLLC by theTrumpets to participate in theSartnership in order to shieldthem from liabilities

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associated with the operationof the partnership's business,TLLC's responsibility for 50%of the debt is nominal and notreal. However, the Trumpetscapitalized TLLC withsubstantial assets($21,000,000 in equity) andthe application of thisposition to the facts at handseems unwarranted.

(3) The application of the steps describedabove to TLLC's contribution of the TajMahal Grove to the partnership inexchange for its partnership interestwill be as follows:

$ 10,000,000 Adjusted basis in property (§722)+ 4,500,000 50% share of partners hip debt

(§5752(a) and 722)- 9.000.000 Assumption of existing mortgage

debt by partnership (SS752(b) and733)

$ 5,500,000 Basis of TLLC in its partnershipinterest

TLLC will recognize no gain or loss byreason of the contribution. §721(a).

(4) The Service might take the position thatS707.(a)(2)(B) should apply to a portionof the $6,000,000 mortgage encumberingthe Second Parcel which was assumed bythe partnership. The Service's argumentwould be predicated upon the fact thatthe Trumpets refinanced the $3,000,000urchase money mortgage on the Secondarcel in early 2000 and increased the

debt to $6,000,000. The additional$3,000,000 was used by the Trumpets tofinance the purchase of an unrelatedpiece of property. The question to beaddressed under §707(a)(2)B) is whetherthe borrowing of the additional$3 000,000 and the assumption of thedebt in late 2001 by the partnershipwere related and should be treated as adisguised sale. Any debt which isassumed by the partnership and which wasincurred less than two years prior tothe date of contribution, will betreated as consideration received in asale under S707(a)(2)(B) unless theTrumpets can demonstrate that such debtwas not incurred in anticipation of thetransfer of the partnership. Reg.SS1.707-5(a) (1) 6(i)(B) and (7).However since the Trumpets had notseriousl considered forming apartnership with anyone when therefinancing took place and almost twoyears have elapsed since therefinancing, TLLC and the Trumpets

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should be able to assert a strong casethat §707(a)(2)(B) should not apply.However, the Trumpets must disclose thatthey are treating the liability as aualified liabi lityJ for purposes of707(a)(2)(B). Reg. §1.707-5(a)(7)(ii).

b. TLLC will be entitled to tack itsholding period for the property onto itspartnership interest. Under S1223(1)tacking of holding periods is permittedif the partnership interest is receivedin exchange for a capital asset orproperty used in a trade or businesswhich is described in §1231(b).

c. TLLC's contribution of property with avalue of $30 000,000 and a basis of$10 000,000 to the partnership meansthat the partnership has inherited anunrealized gain of 520,000,000. (Thepartnership's basis in the propertyreceived from TLLC is $10,000,000 under§723.) Under §704(c)(1(A), as amendedby the Revenue Reconciliation Act of1989, all of this latent gain must beallocated to TLLC for tax purposes whenrecognized by the partnership. Thus,the disparity between the book value ofthe Taj Mahal Grove contributed by TLLCto the partnership and its tax basis(see, discussion of difference betweenbook value and tax basis in PartIV.A.4 infra) will ultimately beeliminated when the property is disposedof in a taxable transaction. (Note thatif the property had been depreciable,the book tax disparity would have beeneliminated on a more rapid basis throughspecial allocations of depreciation.)

d. The economic arrangement agreed to amongTLLC, Developer and Nicklaus providesfor allocations of profits, losses andcash flow in a manner which differsfrom, and is disproportionate to, theagreed values of the capitalcontributions made by the parties.These allocations will be respected bthe Service if they meet any one of thefollowing criteria:

(i) the allocations have 1substantialeconomic effects as determinedunder Reg. S1.7U4-1(b)(2);

(ii) the allocations are in accordancewith the partners' interests in thepartnership determined by takinginto account all facts andcircumstances as determined underReg. S1.704-i(b) (3); or

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(iii) the allocations are deemed to be inaccordance with the partners'interests in the partnership underone of the special rules set forthin Reg. §1.794-1(b)(4). See, Reg.§1.704-1(b) (1)(i).

Since the second and third alternativesare dependent upon facts andcircumstances and are inherentlysubjective, the safest method to insurethat the partners' allocations will beaccepted by the Service is to complywith the substantial economic effectsafe harbor established under Reg.§1.704-1(b)(2). In order to availthemselves of this safe harbor, theartners' allocations must both haveeconomic effectJ and must besubstantial.1 leg. §1.704-1(b) (2) (i).

(1) In order to have leconomic effect,1the partnership agreement musttrovide for the followinghroughout the full term of the

partnership:

(a) for the determination andmaintenance of the partners'capital accounts in accordancewith Reg. S1.704-i(b) (2) (iv);

(b) upon the liquidation of thepartnership (or any partner'sinterest in the partnership),liquidating distributions arerequired in all cases to bemade in accordance with thepositive capital accountbalances of the partners andsuch distributions are to bemade within the time periodreferred to in theregulations; and

(c) if a partner has a deficitbalance in his capital accountfollowing the liquidation ofhis interest in thepartnership (taking intoaccount certain adjustments),such partner must beunconditionally obligated torestore the amount of suchdeficit balance to the part-nership by the end of thetaxable year in which theliquidation takes glace (or,if later, within 9 days afterthe date of such liquidation).

If the partnership agreementprovides for the maintenance ofcapital accounts and for

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distributions upon liquidation inaccordance with positive balancesin capital accounts, but fails tomeet the deficit restorationobligations set forth above theregu ations establish an alernateeconomic effect test which willenable a partner who is notobligated to restore a negativecapital account balance to availitself of the safe harbor if thertnership agreement contains aualified income offset.1 Reg.

P.704-i(b)(2) (ii) (d).

(2) The economic effect of anallocation will be 1substantiall ifthere is a reasonable possibilitythat the allocation will affectsubstantially the dollar amounts tobe received by the partners fromthe partnership, independent of taxconsequences. The rules fordetermining substantiality are setforth in Reg. S1.704-i(b)(2) (iii).

The allocations described in PartIV.A.4., supra, comply with therequirements set forth above and suchallocations will, therefore, berespected for tax purposes.

e. A partnership is a flexible form ofentity that is ideally suited forthis venture. It is a passthroughentity which means that the incomeof the entity will not be subjectto tax at the entity level butinstead will pass t rough to itspartners. Likewise, losses willflow through to the partnerssubject to the basis limitationrules of §704(d). However thesefavorable tax benefits will only beavailable to TLLC and the otherpartners if the partnership will bereated as a partnership forfederal income tax pur oses. Sincea limited partnership has many ofthe same features as a corporation,the issue is whether the entitywill be treated for tax purposes asa partnership or a corporation.

The determination of whether anentity will be recognized as apartnership (rather than acorporation) for tax purposes isnow governed by Reg. S3 01.7701-1and , the so-called check-the-bo xregulations. Under the check-the-box regulations, a partnership(including a limited partnership)that is formed under the law of the

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State of Florida or any other statewhich will be recognized as apartnership for federal income taxpurposes unless the partnership

as an association, taxable as acorporation. Reg. §301.7701-3(a)and (b). The check-the-boxregulations became effective as ofJanuary 1, 1997. These regulationsare in marked contrast to the fourfactor tests of old Reg. §301.7701-2. Thus, the new limitedpartnership formed by TLLC,Developer and Tiger Nicklaus willautomatically be classified as apartnership for tax purposes unlesshe partners file IRS Form 8832

with the Service affirmativelyelecting to be classified as acorporation (which the parties willnot file because all of them desireto have the limited partnershiptreated as a partnership for taxpurposes).

C. Tax consequences to Tiger Nicklaus.

1. Profits interest for future services. Thelimited partnership interest to be issued toTiqer Nicklaus does not require Nicklaus tomake a capital contribution to thepartnership. Nicklaus will receive asecondary profits interest which will enablehim to snare in profits of the partnership inexcess of $2,500,000 per year. Inconsideration for such interest, Nicklaus isrequired to promote the partnership'sdevelopment project throughout the UnitedStates and the world for a period of fiveyears. If Nicklaus ceases to render suchservices at any time prior to the expirationof such 5-year period, his interest in thepartnership will be terminated and he willonly be entitled to any partnership profitspreviously accrued on his behalf and whichremain undistributed at such time (i.e. thepositive balance in his capital account).

a. In many cases a service partner is notgiven an interest in partnershipcapital but receives instead aninterest in future profits of thepartnership for his services. Reg.§1.721-1(b)(1) deals with the taxtreatment of such event in a rathercircuitous fashion as evidenced by thefollowing:

h To the extent that any ofe partners gives up any part of

his riht io be repaid hiscontrigutions (as distinguished

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profits) in favor of another.part-ner as compensation for services

section 721 does not apply.1[Emphasis supplied]

The underscored parenthetical appears toexempt the receipt of an interest inpartnership profits for services fromtaxation and this interpretation of theregulations was accepted by most taxVractitioners prior to 1971. See, e.g,illis, Willis on Partnership T-axation(ist Ed.) S9.07 (McGraw-Hill 1971).

(1) This position was supported by afootnote to the Tax Court's opinionin Hale v. Commissioner, 24 T.C.M.1497 (1965) which provided that I .• . under the regulations, the merereceipt of a partnership interestin future profits does not createany tax liability.1 24 T.C.M. at1502, n.3.

(2) The Service also added credibilityto this position in Rev. Rul. 60-31, 1960-1 C.B. 174, as modified byRev. Rul. 70-435, 1970-2 C.B. 100,Ex. 5.

b. In 1971 the Tax Court, in a unanimousreviewed decision in Diamond v.Commissioner, 56 T.C. 530 (1971), aff'd.492 F. 2d 286 (7th Cir. 1974), heldthatthe receipt of an interest in theprofits of a partnership inconsideration for services previouslyrendered constituted taxable income tothe recipient. The Tax Court in Diamondcommented that the meaning of theparenthetical reference to a profitsinterest in Reg. §1.721-l(b)(1) was1obscures and went on to hold that,since neither §721 nor the regulationsthereunder specifically exempted acompensatory transfer of a partnershipprofits interest from taxation, thetransfer of the profits interest to thetaxpayer in Diamond should be governedby the general statutory provisions of§61. 56 T.C. 530, 546.

(1) The Tax Court's opinion in Diamondappears to distinguish between thereceipt of an interest in theprofits of a partnership for pastservices and the receipt of such aninterest for future services withthe implication that the lattercase might not be taxable.

(2) The Seventh Circuit, in affirmingthe Tax Court's decision inDiamond, did not make a similar

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distinction between a profitsinterest received for past orfuture services, but indicated thatthe determination of whether aSrofits interest will result inaxable income to the servicepartner will be determined bywhether the interest has anascertainable value.1 The Seventhircuit's opinion implies that this

will be more the exception than therule.

(3) The Seventh Circuit's opinion inDiamond also addresses the factthEattaxation of the servicepartner on the present value of aprofits interest may result indouble taxation because he will betaxed initially on the value ofsuch interest and then again onthese future profits when they arerealized. The Court's suggestedsolution to the problem is to allowa taxpayer to amortize the value ofhis interest and the Court urgedthe Commissioner to promulgateregulations establishing a methodof doing so.

c. Approximately five years after theSeventh Circuit handed down its opinionin Diamond, the Service issued GeneralCounsel Memorandum 36346 (7/25/77) whichannounced that the Service would notfollow the Diamond decision with respectto a compensatory transfer of a profitsinterest in a partnership in exchangefor services. The GCM defines a profitsinterest as one which gives the holderno rights to existing assets uponliquidation. The primary concern of theGCM is that a purported partnershipprofits interest might insteadconstitute a disguised interest inpartnership capital. Thus, for example,if the assets of the partnership areunder-valued such that a sale of thepartnership's assets at fair marketvalue immediately after the receipt ofthe partnership interest by the servicepartner, followed by a liquidation anddistribution of proceeds would result inthe service partner receiving anyproceeds, then the service partner wouldbe deemed to have received an interestin partnership capital (which is clearlytaxable under Reg. §1.721-1(b) (1))rather than an interest purely inpartnership profits.

d. Subsequent to the issuance of GCM 36346and prior to 1990, there were only threecases decided involving the receipt of a

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partnership profits interest forservices. In each of these cases thecourt ado pted the Diamond approach byholding that the receipt of apartnership profits interest forservices is a taxable event under $61and is subject also to §83 (governingthe receipt of property for services).However, in each case the court adoptedthe liquidation method of valuing theprofits interest described in GCM 36346which resulted in nominal value for theinterest. See, St. Johns v. UnitedStates, 84-1 U.S.T.C. 9158.(C.D. Ill.1983k; Kenroy, Inc. v. Commissioner, 47T.C.M. 1749 (1984); and National Oil Co.v. Commissioner, 52 T.C.M. 1223 (1986).

e. On March 27, 1990, the Tax Court handeddown its decision in William G. CamDbellv. Commissioner, 59 T.C.M. 236 (1990).The Tax Court's opinion in Campbell heldthat the receipt of a partnershipprofits interest in exchange forservices rendered prior to the formationof the partnership is a taxable eventand that the value of the partnershipinterest is taxable to the recipientunder §61, subject to the timing andcharacterization rules of §83. However,unlike St. John, Kenroy, Inc. andNational Oil Co., which went through ahypothetical liquidation by thepartnership of all of its assets and adistribution of the proceeds thereof tothe partners in order to value theinterest of the service partner, the TaxCourt in Campbell resorted to aprolonged analysis of future incomestream and future tax benefits, all ofwhich were quantified and discountedback to present value in order to valuethe profits interest received by theservice partner. It appears from theopinion that, if the Court had employeda liquidation approach to value theinterests the interests would have hada speculative or zero value in eachinstance. The Tax Court thus refused toacknowledge the limitations placed onits holding in Diamond by the SeventhCircuit. Moreover, the Courtdemonstrated an a pparent willingness tograpple with the task of valuing almostany profits interest, no matter howspeculative the value might be.

f. It was for this reason that the EighthCircuit reversed Campbell and held infavor of the taxpayer on the groundsthat the profits interest hadspeculative value. Using the rationaleof the Seventh Circuit in Diamond, theEighth Circuit reasoned that the

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taxpayer had received no quantifiabletaxable income. Thus, the reversal inCampbell was achieved on the basis ofthe value, or lack thereof, of theprofits interest. See, also, Pacheco,912 F.2d 297 (9th Cir. 199-0) in whichthe Ninth Circuit unequivocably statedthat Diamond stood for the limitedEroposition that if a profits interestas a Ideterminable marketable value at

the moment of creation, the interest istaxable under Section 7 1 but that sucha case was distinguishable from theypical situationss where the profits

interest swill have only a speculativevalue, if any.1

g. On June 19, 1993, the Service issuedRev. Proc. 93-27, 1993-2 C.B. 343 inwhich the Service announced that atransfer of a partnership profitsinterest to a service partner inconsideration for services rendered toor for the benefit of the partnershipwill generally not be a taxable event.Rev. Proc. 93-27 also fills a void inboth the existing and proposedregulations under Section 721 byprovidin definitions of both a ca italinteres and a 1profits interes .-

(1) Section 2.01 of Rev. Proc. 93-27states that a capital interest isan interest that would give a

Wolder a share of the proceeds ifthe partnership's assets were soldat fair market value and then theproceeds were distributed in acomplete liquidation of thepartnership.5 This definition,which is designed to prevent acapital interest from beingmasqueraded as a profits interestby under-valuing partnershipproperties € is virtually identicalto he definition in GCM 36,346. Aprofits interest is described inection 2.2 as simply a

spartnership inte est other than acapital interest.e

(2) The safe harbor for compensatorytransfers of partnership interestswill not be available under any ofthe following circumstances (whichare set forth in Section 4.02 ofRev. Proc. 93-27):

(a) The profits interest relatesto the substantially certainand predictable stream ofincome from partnershipassets, such as income from

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high-quality debt securitiesor a high-quality net lease.

(b) The partner disposes of theprofits interest within twoyears of its receipt.

(c) The profits interest is alimited partnership interestin a publicly tradedpartnership as defined in7704(b) of the Code.

h. If the receipt of a special interest byTiger Nicklaus is examined in light ofRev. Proc. 93-27, the following analysisshould apply:

(1) The first issue to be resolved iswhether Nicklaus has received aprofits interest or a capitalinterest. In testing for theexistence of a capital interest,Section 2.01 of Rev. Proc. 93-27creates a hypothetical sale of allof the partnership's assets attheir fair market values, followedby a distribution of the proceedsof such sale in completeliquidation of the partnership. Ifthe service partner would havereceived any portion of theliquidating distribution withrespect to the partnership interestreceived in exchange for services,the interest will be a capitalinterest. Assume for this purposethat the interest received by TigerNicklaus would not be treated as acapital interest under this test.

(a) In the case of the partnershipinterest received by TigerNicklaus another veryimportant issue to be resolvedis when the interest is to betesE e--to determine if it is acapital interest or a profitsinterest. The interest to bereceived by Nicklaus will beforfeited if Tiger Nicklausceases rendering services atany time during the initial 5-year period. The partnershipagreement also provides thatthe interest is non-transferable during thisperiod. Based upon theseacts, the lpropertyv (i.e.,the partnership interest) tobe received by Nicklaus willbe treated as a non-vestedinterest under §83. See, Reg.§1.83-3(c). Under the general

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rules of $83(a), income willbe recognized at such time asthe interest first becomesvested and the measure of theincome will be the value ofthe partnership interest atthat time over the amount-ifany paid by the servicepartner for his partnershipinterest. If, as noted above,the partnershp interest to bereceived by Tiger Nicklaus istested at the time theinterest is initially grantedto Nicklaus, it will qualifyas a profits interest.However, if the vestingrequirements under §837a) aredeemed to suspend the time fortesting the interest theinterest may very well beconverted from a profitsinterest to a capital interestbecause the interest may buildup value over the 5-yearvesting period. However, theService has recently issuedguidance in Rev. Proc. 2001-3, 2001-34 IRB 191 indicating

that a service provider whoreceives an unvested rofitsinterest which meets thereguirements of the Procedurewill not recognize incomeeither at the time theinterest is received or at thetime it vests.

(2) Two other requirements of Rev.Proc. 93-27 are that the servicesrendered by Tiger Nicklaus must beo or for the benefit of the

partnership,1 and must be renderedin Nicklaus' capacity as a partnerin the partnership. Both of theserequirements would appear to be metin the case of Tiger Nicklaus.

The regulations under §83 also pose someadditional potentially troublesomeproblems to Tiger Nicklaus and to thepartnership.

(1) Reg. S1.83-1(a)(1) provides thatthe transferor of property to aservice provider will be deemed tostill be the owner of the propertyfor tax purposes until such time asincome is recognized by the serviceprovider (i.e., when the interestbecomes vested or an election under§83(b) is made). The regulationalso provides that any incomeIreceiveds from such property

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during the interim period willconstitute additional compensationin the recipient's taxable year ofreceipt. If applied literally tothe profits interest received byTiger Nicklaus and if Nicklausfailed to file a §83(b) election,Nicklaus would presumably not berecognized as a partner for taxpurposes until the restrictionslapse. Thus, Nicklaus' jallocableshares of profits might-be requiredto be reallocated to the otherpartners, even though the economicenefit associated with suchSrofits inures to the benefit oficklaus. In addition, all cash

distributions from the partnershipto Nicklaus would, if thisregulation were applied, be taxedto him as ordinary income ratherthan being received as a tax-free(to the extent of basis)distribution under §731.

(2) Reg. §1.83-6ib) requires that thetransferor of property in a $83

compensatory transfer recognizegain or loss equal to thedifference between (i) the amountpaid (if any) by the transferee ofthe property plus the amount of the*deduction (or capital expenditure)to the transferor under §83(h), and(ii) the transferor's basis in theproperty. The Service has notissued any guidance as to how thisRegulation would apply in the caseof the transfer of a partnershipprofits interest or capitalinterest for services.

D. Tax consequences to Developer.

1. Possible Diamond gain. It is possible thatDeveloper's 50% interest in profits will bedeemed to have been received in part inexchange for future services (i.e., Developerwill contribute 16% of the total capital ofthe partnership but will have a 50%, interestin profits and losses). If so, thediscussion under Part IV.C., supra, will beapplicable.

2. Basis. Developer's initial basis in itspartnership interest will be $4 000,000attributable to money contributed) plus

14 500 000 (deemed contribution by virtue ofalloca ion of one-half of partnership debt toDeveloper). SS722 and 752(a); Reg. §1.752-l(b). If Developer is forced to recognizeincome under Diamond, its basis will also beincreased by the amount of such income.§1012.

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3. Holding period. No tacking of holding periodwith respect to Developer since Developercontributed only money (or money plusservices) to the partnership in exchange forits interest. Reg. §1.1223-1(a).

4. Treatment of fees. Management, sales andrental fees will be treated as guaranteedpayments to Developer because they areetermined without regard to partnershipincome. §707(c).

E. Tax consequences to partnership.

1. No gain or loss recognized fromcontributions. The partnership willrecognize no gain or loss upon the receipt ofproperty and money in exchange forpartnership interests. §721.

2. Basis in contributed property. Thepartnership's basis in the Taj Mahal Grovewill be a carryover basis. §723.

3. Holding periods. The partnership will beentitled to tack the holding period withrespect to the Taj Mahal Grove. §1223(2).

4. Amortization of organizational expenses. A60-month amortization of organizationexpenses is available under §709 if properlyelected.

5. Partnership's corollary to Diamond gains. Ifeither Developer or Nicklaus is deemed tohave received compensation income as a resultof the receipt of a partnership interest forservices, the partnership may have adeduction in an equal amount under S162 or,alternatively, may be deemed to have made acapital expenditure under $263. §83(h) andReg. S1.83-6(a). In addition, thepartnership may be deemed to have recognizedincome under Reg. §1.83-6(b) if it isdetermined that the profits interestdistributed to the service partnerconstitutes appreciated property. S,discussion under Part IV.C..i.(2), -sura.

6. Guaranteed payments. Guaranteed payments toDeveloper for management sales and rentalfees will either be treated as deductibletrade or business expenses under §162 or as acapital expenditures under §263, dependingupon the circumstances giving rise to thepayment. §707(c); Caqle v. Commissioner, 63

C. 86, affd. 539 F.2d 409 (5th Cir.1976); and Gaines v. Commissioner, 45 T.C.M.363 (1982).

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