Tax Court Lacked Jurisdiction to Review Disallowed Section 1031 Exchange

(Parker Tax Publishing June 2020)

The Tax Court held that it did not have jurisdiction over a deficiency arising from a taxpayer's deferral of gain based on a purported like-kind exchange where the IRS disallowed the deferral based on a return it received from a partnership that was subject to the TEFRA unified audit procedures. The court found that the disallowance of the like-kind exchange treatment was a computational affected item that the IRS was authorized to immediately assess and that was not subject to deficiency procedures. Gluck v. Comm'r, T.C. Memo. 2020-66.

Background

In June 2012, Laurence Gluck sold a condo in New York City for $10,214,000. Wishing to defer recognition of gain on the sale under Code Sec. 1031, Gluck began a search for replacement property that would qualify for like-kind exchange treatment. Gluck deposited the sale proceeds into a qualified escrow account with Royal Abstract Deferred, LLC (Royal Abstract), which acted as an escrow agent.

Gluck identified 145 East 74th Street in Manhattan, a rental apartment building (i.e., the property), as a possible replacement property. He formed 145 East 74th Owner, LLC (Gluck LLC), a single-member LLC which was treated as a disregarded entity for federal income tax purposes. In November 2012, Gluck LLC executed a contract in which it purported to acquire a 12.5 percent interest in the property. The contract listed the purchaser as Gluck LLC and the seller as the estate of Arthur D. Emil. Later that month, Gluck LLC entered into a substantially similar contract with Judy Tenney to acquire another 12.5 percent interest in the property. Gluck LLC assigned to Royal Abstract its rights under the two purchase contracts, and Royal Abstract completed the transaction by delivering proceeds to the sellers from Gluck's qualified escrow account.

Gluck's tax return for 2012 included a Form 8824, Like-Kind Exchanges, stating that Gluck had engaged in a like-kind exchange and describing the replacement property as 145 East 74th Street. The Form 8824 reported that the amount of the gain deferred under Code Sec. 1031 was $10,042,886. However, Gluck's reporting was not consistent with the reporting that the IRS received from a partnership called Greenberg & Portnoy (G&P). G&P's return reported that it owned the property at 145 East 74th Street and that Gluck LLC acquired a partnership interest in G&P, as opposed to a direct ownership interest in the apartment building. As in effect in 2012, Code Sec. 1031 provided that like-kind exchange treatment did not apply to any exchange of interests in a partnership.

Gluck received a Schedule K-1 from G&P reporting Gluck's contribution of capital to, and his distributive share of income from, the partnership. Gluck did not report his distributive share of G&P's income on his 2012 tax return and did not file a Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR). The IRS audited Gluck's 2012 return and issued a notice of deficiency disallowing the deferral of gain and determining an accuracy-related penalty. Gluck took his case to the Tax Court, and the IRS moved to dismiss the case for lack of jurisdiction.

The TEFRA unified audit and litigation procedures, which applied to certain partnerships before 2018, limit the Tax Court's jurisdiction to redetermine a deficiency in several respects. Under pre-2018 Code Sec. 6230(a)(1), the Tax Court's deficiency jurisdiction generally does not apply to the assessment or collection of any computational adjustment made with respect to a partner in a partnership that is subject to TEFRA. Under pre-2018 Code Sec. 6231(a)(6) and Reg. Sec. 301.6231(a)(6)-1(a), a computational adjustment includes the change in a partner's tax liability that reflects a change in an affected item, where that change is necessary to properly reflect the treatment of a partnership item. If the affected item is a factual affected item, meaning that it requires partner-level factual determinations (e.g., whether a partner is at-risk with respect to his or investment in the partnership), the item is subject to deficiency procedures. However, if an affected item is a computational affected item - an item that can be determined automatically once the relevant partnership item has been determined - then the deficiency procedures do not apply.

The IRS contended that the Tax Court lacked jurisdiction because the adjustment to Gluck's tax liability attributable to the disallowance of like-kind exchange treatment was a computational adjustment that properly reflected the treatment of a partnership item - Gluck LLC's interest in G&P - on G&P's tax return. Gluck responded that there was no legal entity with the name of Greenberg & Portnoy. He suggested that computational adjustments should be limited to numerical or mathematical operations by the IRS. He contended that the purported like-kind exchange could not be properly regarded as a partnership item. Finally, Gluck argued that it would have been impossible for him to suspect that G&P had filed a partnership return.

Tax Court's Analysis

The Tax Court granted the IRS's motion to dismiss after holding that it did not have jurisdiction to redetermine Gluck's deficiency. The Tax Court found that Gluck's entitlement to Code Sec. 1031 treatment was a computational affected item that was exempt from deficiency procedures. In the court's view, it was clear that no partner-level factual determinations were required. Rather, once Gluck LLC was deemed to have acquired a partnership interest rather than a real estate interest, consistently with the treatment of partnership items on G&P's return, Gluck's non-entitlement to Code Sec. 1031 deferral followed automatically as a matter of law. The court said that this result did not depend on any facts or circumstances particular to Gluck or Gluck LLC.

The Tax Court rejected Gluck's arguments. The court found that G&P's existence as a valid partnership was a partnership item that had to be decided in a partnership-level proceeding. The court found that computational adjustments are defined broadly and are not limited to numerical or mathematical operations. The court agreed with Gluck that the purported like-kind exchange was not a partnership item, and explained that the relevant partnership items were G&P's validity as a partnership, Gluck LLC's status as a partner, and the ownership of the property. According to the court, Gluck's claim to like-kind exchange was completely inconsistent with the treatment of these partnership items on G&P's return. Therefore, the denial of like-kind exchange treatment was a computational adjustment, because it was a change in Gluck's tax liability which properly reflected the treatment of the relevant partnership items. The court explained that many computational adjustments involve changes to tax items that appear on the partner's return only.

Finally, the court found that it was plainly not the case that it was impossible for Gluck to know that a partnership return had been filed for G&P. The court reasoned that Gluck or his advisors presumably did due diligence before finalizing an investment of $9.25 million in the property. The court found that financial statements clearly stated that G&P was organized as a partnership to acquire and operate the property for the purpose of generating rental income. Further, Gluck acknowledged receiving a Schedule K-1 from G&P, and the court said that had Gluck filed a Form 8082, that would enabled the IRS to open a partnership audit of G&P in order to determine which treatment was correct. At the very least, in the court's view, Gluck could have contacted G&P at the address shown on the K-1. Having failed to do any of this, the court concluded that Gluck opened himself up to a computational adjustment that the IRS was authorized to assess immediately.

However, with respect to the penalty assessed on Gluck's deficiency, the court found that it did have jurisdiction because accuracy-related penalties are nonpartnership items and are subject to deficiency proceedings unless they are computational affected items. The court reasoned that the penalty was not a computational affected item because Gluck's liability hinged on factual determinations peculiar to him, e.g., whether he made a good faith effort to correctly determine his tax liability.

For a discussion of TEFRA audit procedures, see Parker Tax ¶28,505.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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