Taxable Talk

Today the Tax Court looked at a §1031 Exchange case. The question before the court was whether a partnership (Peabody) could exchange gold mines for coal mines. The problem: the coal mines were encumbered with supply contracts that sent the coal to electric utilities. Does the encumbrances constitute “boot” that causes tax to be due?

Under a &sect1031 Exchange, like property is exchanged for like property. The exchanger avoids capital gains tax. Like property need not be exactly the same property. You can exchange a rental house for a rental duplex, for example. (There significant restrictions to &1031 exchanges; make sure you talk to your own tax advisor about your situation.)

When cash gets involved in the transaction, it’s considered “boot.” Boot is taxable. The IRS argued that the contracts weren’t real property, but were the equivalent of cash or personal property received along with like-kind property. (There’s no question that you can, in a &sect 1031 exchange, exchange one mine for another mine, even if each mines different substances, assuming the other provisions of &sect 1031 are followed.)

The court had to determine, (1) are supply contracts considered real property and, thus, can be part of a &sect 1031 exchange (the IRS argued that they are contracts to sell personal property); (2) are the servitudes created by the supply contracts real property; and (3) are the supply contracts boot or not?

The court noted that like-kind doesn’t mean exactly the same kind:

In determining whether the like-kind requirement of section 1031 had been met, we found it significant in Koch v. Commissioner, 71 T.C. at 65, that section 1031(a) refers to property of a like, not an identical, kind. The required comparison of the old and new exchanged properties, we reasoned, should be directed to whether the taxpayer, in making the exchange, has used its property to acquire a new kind of asset or has merely exchanged its property for an asset of like nature or character.

The court did note that not all real property exchanges are like-kind exchanges, though.

The idea behind a &sect 1031 exchange is that the taxpayer is exchanging one piece of property for another, and that his original investment has not been sold or liquidated. The court noted,

It is true Peabody is obligated to mine and supply coal to meet the operating needs of power stations and that Peabody is prohibited from impairing the contracted-for supply by selling coal to other buyers. In our view those contract obligations and restrictions constitute a distinction in the grade or quality of the old and new mining properties rather than a difference in their kind or class. The new coal mine property is of a like nature or character to the gold mining property Peabody exchanged. By exchanging the gold mining property for the coal mining property subject to the supply contracts, Peabody is essentially continuing the original investment which remains fully unliquidated.

The court concluded, “In the light of that holding and because the supply contracts cannot be separated from Peabody’s ownership of the Lee Ranch mine coal reserves, it follows that those contracts are not taxable as other property or boot under section 1031(b).”

So Peabody is allowed to turn gold into coal, tax-free.

Case: Peabody Natural Resources Company v. Commissioner, 126 T.C. No. 14

Today the Tax Court looked at a casualty loss case. Many times when casualty loss cases make their way to Tax Court, there’s a dispute about whether or not there really was a loss. Not today.

A fire destroyed the victim’s office on the university campus where he worked as a Professor of Economics. He lost a litany of belongings, which he detailed as follows:

Books on economics $2,000
Books by “famous authors” 1,000
Books on Africa 5,000
African journals & magazines 3,000
Book manuscript 15,000
Memorabilia (awards, plaques, etc.) 3,000
Briefcases, fans, etc. 2,000
Computer printer 250
Labor/inconvenience/distress 2,000

The unlucky victim did receive $12,000 in compensation from the university’s insurance company. The IRS denied a portion of his casualty loss.

When you have a casualty loss, such as a fire, your loss for tax purposes is based on the lessor of your basis in the assets you lose, or the fair market value of the assets. As the Tax Court notes,

“Petitioner, however, has not produced any evidence as to what his bases or costs in the various items may have been. Indeed, while they may have had value to petitioner, it is clear that the memorabilia had no costs to petitioner, and petitioner would have no bases in these items. With respect to what petitioner describes as “Labor/Inconvenience/Distress”, as we understand petitioner’s testimony, the deduction was for mental upset, having to prepare new lecture notes, etc., and for teaching. These are not items of property the losses of which are deductible as casualty losses.”

One point that the Tax Court made is that the petitioner did not avail himself of any professional advice. As Albert Einstein said, “The hardest thing in the world to understand is the income tax.” When in any doubt, get professional tax advice. Any competent tax professional could have set this professor on the right track.

Case: Ayittey v. Commissioner, T.C. Summary 2006-65

Yesterday, there were three interesting Tax Court decisions. Joe Kristan of Roth Tax Updates has an excellent post on the first case. In that case, Merlo v. Commissioner, the unlucky taxpayer found out the “gotcha” of incentive stock options. If you are the recipient of such options, take a look at Joe’s post on this case now. ISO’s have a wonderful tax advantage…but if the option tanks….

The second case has to do with something quite basic: a change of address. In Pragasm v. Commissioner, the taxpayer wanted to have a hearing on a collection (levy/lien) dispute. The IRS said that they weren’t required to hold one because the taxpayer never responded to their notices. The Court sided with the IRS. Just a reminder, if you move, notify the IRS (and your state tax agency, if applicable); you can download Form 8822 here and mail it (certified mail, return receipt requested, of course) to the IRS.

The third case has to do with regulatory requirements. Last May, the Tax Court ruled in Zapara v. Commissioner that the IRS failed to comply with §6335(f) of the I.R.C. That section requires the IRS to sell seized property within sixty days following a request by the taxpayer (and have the proceeds of the sale credited against the tax, penalties, and interest owed). The taxpayers in that case had, the Court ruled, requested such a sale and the IRS did not sell the property (in this case, stock).

The IRS asked the Tax Court to reconsider their May 2005 decision. The IRS claimed that the taxpayers untimely raised a new issue, that the evidence doesn’t support the decision, and that the Court doesn’t hold the power to make the relief ordered in the earlier decision. The IRS lost on all three counts, and the motion for reconsideration was denied (decision here).

Why is this final case important? The Tax Court usually rules based on regulations and paperwork. If you can show paperwork/backup for your actions, and that you followed the regulations/Tax Code, you will usually win. This holds true for the IRS, too. The IRS’s paperwork showed the request to sell the stock, and the stock wasn’t sold. The moral is clear: document, document, document; and you have an excellent chance of winning your case.