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Fact pattern

Taxpayer, LLC (“Taxpayer”) bought land for $300,000 on January 17, 1988 and constructed a building containing residential rental units on a weekly, monthly, seasonal, and annual basis (“RENTACRE”) which was placed in service on June 13, 1988. Taxpayer’s costs to construct the building were $700,000 which include, but are not limited to, construction material costs, legal fees for negotiating the purchase of the land, and salaries for laborers in the preparation of the land and construction of the building. Taxpayer funded the costs of construction of $700,000 with a 15 year non-recourse promissory note from EZCREDIT Bank at 5% interest secured by RENTACRE. In 1998 and 1990, RENTACRE struggled to catch on as a destination and the Taxpayer incurred losses of 200,000 and $150,000 for each year respectively; for those years not all the members of Taxpayer materially participated in the activities of Taxpayer.

The rent on the units by the year 2007 was averaging $400,000 per year to Taxpayer. In 2007, the managing member of New Cape May, LLC (“New Cape May”), which actively operates a bar/restaurant business a half mile away from RENTACRE, approaches Taxpayer with a proposal to exchange the real estate in the bar/restaurant business for RENTACRE. Taxpayer has missed some payments on the EZCREDIT Bank note which still has a balance of $300,000 while the New Cape May’s bar restaurant property is not subject to any debt. In 2007, the fair market of the land on which New Cape May’s bar business was located was $1,500,000 and the fair market value of RENTACRE was $2,000,000 and Taxpayer’s basis in the apartment building on RENTACRE is $190,000.

However, Taxpayer decides not to pursue the transaction because it receives advice from its tax lawyer that the exchange will not qualify for like-kind exchange because of the debt on RENTACRE and the tax on the exchange would be $543,000 which would be passed through to the members of Taxpayer which the tax lawyer computed as follows

$2,000,000 Amount Realized (Fair Market Value of Property Received)
Minus
$190,000 Adjusted Basis (From RENTACRE)
$1,810,000 Gain Realized
Multiplied by average marginal rate of 30%
$543,000

Instead, Taxpayer and New Cape May negotiate a lease whereby New Cape May leases RENTACRE from Taxpayer for a 10 year lease from January 1, 2007 to January 31, 2017 for a total rental price of $4,500,000 at $450,000 per year payable on annually on the first of the year.

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In 2012, Taxpayer gets an offer to purchase RENTACRE from a third party, SELLCO, LLC, (“SELLCO”) for $4,750,000 and Taxpayer pays New Cape May $500,000 to cancel the lease. SELLCO decides to shift from rental properties to sales of the units. SELLCO decides to form a cooperative corporation and is told by their lawyer that the owners of the cooperative will be treated as a partnership for tax purposes and nothing further needs to be done to obtain that tax treatment from the IRS.

1. Based only on what you see above, do you have enough information to conclude without the benefit of making other assumptions that each member of Taxpayer will be able to use the losses from 1989 and 1990? Explain your answer.

2. Is the legal opinion given to Taxpayer in 2007 regarding the exchange correct? Explain your answer.

3. Assume the proposed exchange between Taxpayer and New Cape qualifies for like kind treatment, do you have enough information to know what Taxpayer’s basis in the land on which the bar/restaurant would be if Taxpayer agreed to the exchange? Explain your answer.

4. Does New Cape May have income from the lease cancellation payment and if so, what is the character of the income? Explain you answer.

5. If SELLCO does shift to sales of units exclusively can SELLCO be confident that all proceeds of sales from the units will be treated as capital gain and will never under any circumstance give rise to ordinary income? Explain your answer.

6. Is the legal opinion given to SELLCO correct? Explain your answer.

7. Evaluate SELLCO’s choice of a cooperative corporation as form of ownership, identify the alternatives to a cooperative corporation and discuss the tax treatment of the alternatives. Explain your answer.

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