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Like-kind-exchange related party rule triggered gain recognition despite use of qualified intermediary

Ocmulgee Fields, Inc. (2009) 132 TC No. 6

Mike Habib, EA Tax Relief Services

The Tax Court has held that a taxpayer could not avoid the like-kind-exchange related-party rule by using a qualified intermediary. The taxpayer had to recognize gain on its exchange even though it had intended at the outset of the transaction to effect a like-kind swap with a non-related party.

Background. If statutory identification and replacement period requirements are met, gain or loss isn’t recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code Sec. 1031) Qualified intermediaries (QIs) may be used to structure like-kind exchanges. However, under Code Sec. 1031(f) , gain or loss on an exchange between related persons (under Code Sec. 267(b) or Code Sec. 707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules doesn’t apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code Sec. 1031(f)(4)) However, under Code Sec. 1031(f)(2)(C), a disposition won’t trigger the related party bar if it is established to IRS’s satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.

In Teruya Brothers, Ltd. & Subsidiaries (2005) 124 TC No. 4, dealing with a like kind exchange between related parties effected through a QI, the Tax Court held that the transactions involved were economically equivalent to direct exchanges of properties between the related parties, followed by the sale of property by one of the related parties to unrelated third parties. The interposition of a qualified intermediary couldn’t obscure the end result. The Tax Court agreed with IRS that the transactions ran afoul of Code Sec. 1031(f)(4).

Facts. The essential facts of the new Tax Court case are as follows:

(1) Ucmulgee Fields, Inc. (UFI) transferred appreciated property it owned (Wesleyan Station) to a QI. UFI had a $716,000 basis in the property and it was worth approximately $7 million.

(2) An unrelated third party bought Wesleyan Station from the QI for $7.25 million. (3) Treaty Fields, an entity related to UFI, sold appreciated property in which it had an adjusted basis of $2.55 million (the Barnes & Noble Corner) to the QI. The sale price was $6.74 million. Years before, UFI had sold the Barnes &Noble Corner to Treaty Fields.

(4) The QI transferred the Barnes & Noble Corner to UFI.

When UFI initiated the series of transactions, it intended to swap its property for replacement property from an unrelated party, but once the property was transferred to the QI, it couldn’t find suitable replacement property within the statutory identification and replacement periods. The Barnes & Noble was adjacent to property that UFI already owned.

UFI realized a gain of about $6 million but treated its part of the transaction as a like-kind tax-deferred exchange under Code Sec. 1031. Treaty Fields reported its part of the transaction as a taxable sale and reported a gain of about $ 4 million.

IRS said UFI wasn’t entitled to treat the transaction as a like-kind, tax-deferred exchange because Code Sec. 1031(f)(4) applied to the transaction, and the Tax Court agreed with IRS.

Tax Court’s reasoning. The Tax Court said that in the absence of the general rule of Code Sec. 1031(f)(1), a taxpayer anticipating the sale of low basis property might be tempted to exchange the low basis property for high basis property owned by a related person, with the related person then selling the property received in the exchange at a reduced gain (or possibly a loss) because of the shift to that property of his high basis in the property relinquished. Relying on its Teruya Brothers decision, the Tax Court said that to determine UFI’s exchange was part of a transaction or series of transactions structured to avoid the purposes of Code Sec. 1031(f), it had to disregard that exchange and consider how UFI would have fared had it instead exchanged Wesleyan Station with Treaty Fields for the Barnes & Noble Corner and had Treaty Fields then sell Wesleyan Station. The immediate tax consequences resulting from UFI’s deemed exchange with Treaty Fields included an approximately $1.8 million reduction in taxable gain and Treaty Fields paying tax on its gain at a much lower rate than UFI would have paid.

The Tax Court was not convinced by UFI’s argument that tax avoidance was not a principal purpose of the deemed exchange because there was a business reason for exchanging Wesleyan Station for the Barnes & Noble Corner in that the swap allowed UFI to reunite ownership of the Barnes & Noble Corner with other contiguous property that it owned, thereby yielding operating efficiencies and increasing the overall value of the reunited property. Beyond self-serving testimony, UFI didn’t offer evidence to support that claim. The Tax Court equally was not convinced of UFI’s effort to distinguish itself from the Teruya Brothers situation by arguing that it had not structured the entire exchange to avoid Code Sec. 1031(f). Moreover, even if UFI were able to show a legitimate business purpose for the acquisition of the Barnes & Noble Corner, that would not necessarily preclude a finding that either the deemed exchange of Wesleyan Station for the Barnes & Noble Corner or Treaty Fields’s deemed sale of Wesleyan Station had as a principal purpose the avoidance of Federal income tax.

The Tax Court concluded that the end result of UFI’s exchange of Wesleyan Station for the Barnes & Noble Corner was the same as if it had made an exchange of Wesleyan Station with Treaty Fields followed by Treaty Fields’s sale of Wesleyan Station. UFI failed to show that the deemed transaction lacked as a principal purpose the avoidance of Federal income tax. As a result, the actual exchange was part of a transaction structured to avoid the purposes of section Code Sec. 1031(f) and, under Code Sec. 1031(f)(4), the nonrecognition provisions of Code Sec. 1031 did not apply to the exchange.

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IRS OKs use of one property to engineer a reverse and forward like-kind swap Chief Counsel Advice 200836024

In Chief Counsel Advice (CCA), IRS has given its blessing to the use of one property to engineer both a completed reverse like kind exchange and an attempted forward like kind exchange. The forward exchange was necessary because the value of the relinquished property far exceeded the value of the replacement property that the taxpayer received. Because the forward exchange couldn’t be completed within the statutory time limits, however, the taxpayer wound up paying tax on the net cash it received.

Observation: The new CCA is noteworthy because it shows how far the like-kind exchange rules can be stretched, with IRS‘s approval, to accommodate complex conditions.

Background. In general, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment. (Code Sec. 1031) Like-kind treatment is barred if the property to be received is not identified (e.g., by being specified in the contract) on or before 45 days after the transfer, or isn’t received within 180 days after the transfer or by the due date (with extensions) of the return for the year of transfer if earlier. (Code Sec. 1031(a)(3))

Qualified intermediaries (QIs) may be used to structure like-kind exchanges using qualified exchange accommodation arrangements (QEAAs). (Reg. § 1.1031(k)-1(g)(4)) Under established rulings policy, IRS will treat an exchange accommodation titleholder () as the beneficial owner of property for federal income tax purposes if the property is held in a qualified exchange accommodation arrangement (QEAA).

A like-kind exchange can be set up in “forward” or “reverse” mode:

  • In a “forward” (or regular) deferred like-kind exchange using a QI, the taxpayer transfers the relinquished property to the QI, who will sell the property to a buyer. The QI then takes the proceeds of the sale of the relinquished property, buys the replacement property, and transfers the replacement property to the taxpayer.
  • In a “reverse” deferred like-kind exchange, the replacement property is acquired first by the QI (typically using money borrowed from the taxpayer). The taxpayer then identifies relinquished property and transfers it to the QI, who sells it to an outside buyer. Finally, the QI transfers the replacement property to the taxpayer.

Rev Proc 2000-37, 2002-2 CB 308, tailors the 45-day and 180-day statutory periods to the specific situation of QEAAs holding title to property involved in a multiparty exchange.

Facts. A taxpayer we’ll call Hotels, Inc., wanted to acquire a building in Phoenix, Arizona. However, instead of buying it, Hotels wanted to engineer the acquisition as an exchange for one of the buildings it owned elsewhere. To that end, Hotels entered into a QEAA with EAT, an affiliate of QI. The deal called for EAT to facilitate a parking arrangement and acquire the Phoenix property in a like-kind exchange. EAT agreed to take title to the Phoenix property through a wholly-owned single member limited liability company called RPLLC. Hotels loaned RPLLC funds to buy the Phoenix property, for which RPLLC gave Hotels a promissory note obligating EAT to repay the loan to Hotels if the latter subsequently acquired the Phoenix property from EAT.

The following transactions took place:

  • On Date 1, RPLLC acquired the Phoenix property from Seller, financing the $21 million purchase price by assuming an existing $12 million mortgage on the property and borrowing the $9 million balance from Hotels.
  • On Date 2, thirty-three days after the acquisition of the Phoenix property by EAT through RPLLC, Hotels identified in writing to EAT three like-kind properties it owned to potentially serve as relinquished property for the Phoenix property. One of these properties was a building in Houston.
  • On Date 3, Hotels entered into a written exchange agreement with QI to facilitate the exchange of the Houston building. Hotels assigned to QI the right to receive the net sales proceeds for the Houston building from the company interested in buying it (Buyer).
  • On Date 4, QI, acting on behalf of Hotels, transferred the Houston building to Buyer for a total purchase price of $50 million. The net sales proceeds of $41 million (i.e., $50 million less a $9 million mortgage) were deposited with QI. Also on Date 4, which was 180 days from the acquisition of the Phoenix building by EAT, QI directed EAT to transfer the Phoenix building to Hotels as replacement property for the Houston building for a total of $9 million from the sale of the Houston building and an assumption of a mortgage of $12 million. EAT transferred its 100% membership interest in RPLLC to Hotels, thereby transferring the Houston property to Hotels. In addition, Hotels received $9 million in repayment of EAT‘s obligation under the note.
  • On Date 5, which was 42 days after the sale of the Houston property, Hotels identified in writing to QI three additional properties, which were intended by Hotels to be additional replacement properties for the exchange of the Houston property. However, although Hotels had a bona fide intent to enter into a deferred exchange on Date 4, it failed to acquire any other replacement property in the 180-day period subsequent to Date 4.

Hotels later received the remaining proceeds from the sale of the Houston building from QI. Since the attempted deferred exchange transaction spanned two separate tax years, Taxpayer reported the remaining $32 million gain from the sale of the Houston building in the tax year that included the date it received the remaining proceeds in accordance with the installment sale rules of Code Sec. 453 and Reg. § 1.1031(k)-1(j)(2).

Observation: Although the CCA doesn’t explain the derivation of the “remaining $32 million gain,” it’s apparently the $41 million cash from the sale of the Houston building net of the $9 million cash used to buy the Phoenix building.

Observation: Under Code Sec. 453(a) and Code Sec. 453(b)(1), the installment sale rules must (unless the taxpayer elects out) be used to report gain on the disposition of nondealer property where at least one payment is to be received after the close of the tax year in which the disposition occurs. The installment method may be elected even though no payments are received in the year of sale. Here, although Hotels wound up paying tax on the “cash boot” it received because the forward exchange failed, it nonetheless wound up deferring that tax to a year following the year in which the Houston building was disposed of.

Potential problem. The examiner looking at Hotels’ transactions thought that they violated Congressional intent because (1) there could be up to 360 days between the day on which replacement property is parked with an exchange titleholder at the inception of the reverse exchange and the day the deferred exchange is completed, and (2) Hotels is entitled to two separate 45 day identification periods for the forward and reverse exchanges. The argument, in essence, was that the transactions were contrary to the identification and replacement provisions in Code Sec. 1031(a)(3).

Transactions pass muster. The CCA pointed out that Hotels planned on making two exchanges, not one. A taxpayer has 45 days to identify replacement property in a deferred exchange and 45 days to identify relinquished property once replacement property is parked. Hotels satisfied the identification requirement in both instances. Moreover, a taxpayer may park property with an EAT for 180 days or less. Also, in a deferred exchange, a taxpayer must close its exchange by acquiring replacement property within the exchange period, which is the earlier of 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or the due date (determined with regard to extension) for the taxpayer’s return for the tax year in which the transfer of the relinquished property occurs. The CCA said Hotels stayed within all of these guidelines.

The CCA conceded that neither Code Sec. 1031 and its regs, nor Rev Proc 2002-37 expressly allow the same relinquished property to be used in both a reverse exchange and a forward deferred exchange. However, it concluded that nothing in these authorities prohibits this coupling in the use of the same relinquished property. Also, taxpayers using the revenue procedure are not constrained to exclusively acquire as replacement property only the property parked with the EAT. It also pointed to a long history of the courts giving significant latitude in structuring like-kind exchanges under Code Sec. 1031.

As a result, the CCA concluded that if the statutory and regulatory guidelines were followed (i.e., time limitations, the avoidance of constructive receipt, etc.) and if Hotels stayed within IRS‘s administrative guidelines, the gain it realized on the reverse exchange is deferred under Code Sec. 1031 and the gain on the intended deferred exchange is to be recognized in the tax year that includes the date that Hotels received the remaining proceeds from the sale of the Houston property, in accordance with Reg. § 1.1031(k)-1(j)(2)(ii).

For 1031 tax deferred exchange audit, or 1031 tax deferred IRS problem CLICK HERE.

Like-Kind Exchanges Under IRC Code Section 1031

Mike Habib, EA

Whenever you sell a business or an investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.

The exchange can include like-kind property exclusively or it can include like-kind property along with cash, liabilities and property that are not like-kind. If you receive cash, relief from debt, or property that is not like-kind, however, you may trigger some taxable gain in the year of the exchange. There can be both deferred and recognized gain in the same transaction when a taxpayer exchanges for like-kind property of lesser value.

This fact sheet, the 21st in the Tax Gap series, provides additional guidance to taxpayers regarding the rules and regulations governing deferred like-kind exchanges.

Who qualifies for the Section 1031 exchange?

Owners of investment and business property may qualify for a Section 1031 deferral. Individuals, C corporations, S corporations, partnerships (general or limited), limited liability companies, trusts and any other taxpaying entity may set up an exchange of business or investment properties for business or investment properties under Section 1031.

What are the different structures of a Section 1031 Exchange?

To accomplish a Section 1031 exchange, there must be an exchange of properties. The simplest type of Section 1031 exchange is a simultaneous swap of one property for another.

Deferred exchanges are more complex but allow flexibility. They allow you to dispose of property and subsequently acquire one or more other like-kind replacement properties.

To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property. Taxpayers engaging in deferred exchanges generally use exchange facilitators under exchange agreements pursuant to rules provided in the Income Tax Regulations. .

A reverse exchange is somewhat more complex than a deferred exchange. It involves the acquisition of replacement property through an exchange accommodation titleholder, with whom it is parked for no more than 180 days. During this parking period the taxpayer disposes of its relinquished property to close the exchange.

What property qualifies for a Like-Kind Exchange?

Both the relinquished property you sell and the replacement property you buy must meet certain requirements.

Both properties must be held for use in a trade or business or for investment. Property used primarily for personal use, like a primary residence or a second home or vacation home, does not qualify for like-kind exchange treatment.

Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like-kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.

Real property and personal property can both qualify as exchange properties under Section 1031; but real property can never be like-kind to personal property. In personal property exchanges, the rules pertaining to what qualifies as like-kind are more restrictive than the rules pertaining to real property. As an example, cars are not like-kind to trucks.

Finally, certain types of property are specifically excluded from Section 1031 treatment. Section 1031 does not apply to exchanges of:

* Inventory or stock in trade
* Stocks, bonds, or notes
* Other securities or debt
* Partnership interests
* Certificates of trust

What are the time limits to complete a Section 1031 Deferred Like-Kind Exchange?

While a like-kind exchange does not have to be a simultaneous swap of properties, you must meet two time limits or the entire gain will be taxable. These limits cannot be extended for any circumstance or hardship except in the case of presidentially declared disasters.

The first limit is that you have 45 days from the date you sell the relinquished property to identify potential replacement properties. The identification must be in writing, signed by you and delivered to a person involved in the exchange like the seller of the replacement property or the qualified intermediary. However, notice to your attorney, real estate agent, accountant or similar persons acting as your agent is not sufficient.

Replacement properties must be clearly described in the written identification. In the case of real estate, this means a legal description, street address or distinguishable name. Follow the IRS guidelines for the maximum number and value of properties that can be identified.

The second limit is that the replacement property must be received and the exchange completed no later than 180 days after the sale of the exchanged property or the due date (with extensions) of the income tax return for the tax year in which the relinquished property was sold, whichever is earlier. The replacement property received must be substantially the same as property identified within the 45-day limit described above.

Are there restrictions for deferred and reverse exchanges?

It is important to know that taking control of cash or other proceeds before the exchange is complete may disqualify the entire transaction from like-kind exchange treatment and make ALL gain immediately taxable.

If cash or other proceeds that are not like-kind property are received at the conclusion of the exchange, the transaction will still qualify as a like-kind exchange. Gain may be taxable, but only to the extent of the proceeds that are not like-kind property.

One way to avoid premature receipt of cash or other proceeds is to use a qualified intermediary or other exchange facilitator to hold those proceeds until the exchange is complete.

You can not act as your own facilitator. In addition, your agent (including your real estate agent or broker, investment banker or broker, accountant, attorney, employee or anyone who has worked for you in those capacities within the previous two years) can not act as your facilitator.

Be careful in your selection of a qualified intermediary as there have been recent incidents of intermediaries declaring bankruptcy or otherwise being unable to meet their contractual obligations to the taxpayer. These situations have resulted in taxpayers not meeting the strict timelines set for a deferred or reverse exchange, thereby disqualifying the transaction from Section 1031 deferral of gain. The gain may be taxable in the current year while any losses the taxpayer suffered would be considered under separate code sections.

How do you compute the basis in the new property?

It is critical that you and your tax representative adjust and track basis correctly to comply with Section 1031 regulations.

Gain is deferred, but not forgiven, in a like-kind exchange. You must calculate and keep track of your basis in the new property you acquired in the exchange.

The basis of property acquired in a Section 1031 exchange is the basis of the property given up with some adjustments. This transfer of basis from the relinquished to the replacement property preserves the deferred gain for later recognition. A collateral affect is that the resulting depreciable basis is generally lower than what would otherwise be available if the replacement property were acquired in a taxable transaction.

When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

How do you report Section 1031 Like-Kind Exchanges to the IRS?

You must report an exchange to the IRS on Form 8824, Like-Kind Exchanges and file it with your tax return for the year in which the exchange occurred.

Form 8824 asks for:

* Descriptions of the properties exchanged
* Dates that properties were identified and transferred
* Any relationship between the parties to the exchange
* Value of the like-kind and other property received
* Gain or loss on sale of other (non-like-kind) property given up
* Cash received or paid; liabilities relieved or assumed
* Adjusted basis of like-kind property given up; realized gain

If you do not specifically follow the rules for like-kind exchanges, you may be held liable for taxes, penalties, and interest on your transactions.

Beware of schemes

Taxpayers should be wary of individuals promoting improper use of like-kind exchanges. Typically they are not tax professionals. Sales pitches may encourage taxpayers to exchange non-qualifying vacation or second homes. Many promoters of like-kind exchanges refer to them as “tax-free” exchanges not “tax-deferred” exchanges. Taxpayers may also be advised to claim an exchange despite the fact that they have taken possession of cash proceeds from the sale.

Consult a tax professional or refer to IRS publications for additional assistance with IRC Section 1031 Like-Kind Exchanges.

As an IRS licensed Enrolled Agent (EA) specializing in IRS Tax Problem Resolution, I can represent individuals and businesses in all of the following states, counties, and metro cities, Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Puerto Rico Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington D.C.. West Virginia Wisconsin Wyoming. AL AK AZ AR CA CO CT DE DC FL GA HI ID IL IN IA KS KY LA ME MD MA MI MN MS MO MT NE NV NH NJ NM NY NC ND OH OK OR PA RI SC SD TN TX UT VT VA WA WV WI WY New York, Los Angeles, Orange County, Riverside, San Bernardino, San Francisco, Ventura, Lancaster, Palmdale, Santa Barbara, Chicago, Washington D. C., Silicon Valley, Philadelphia, Boston, Detroit, Dallas, Houston, Atlanta, Miami, Seattle, Phoenix, Minneapolis, Cleveland, San Diego, St Louis, Denver, San Juan, Tampa, Pittsburgh, Portland, Cincinnati, Sacramento, Kansas City, Milwaukee, Orlando, Indianapolis, San Antonio, Norfolk & VB, Las Vegas, Columbus, Charlotte, New Orleans, Salt Lake City, Greensboro, Austin, Nashville, Providence, Raleigh, Hartford, Buffalo, Memphis, West Palm Beach, Jacksonville, Rochester, Grand Rapids, Reno, Oklahoma City, Louisville, Richmond, Greenville, Dayton, Fresno, Birmingham, Honolulu, Albany, Tucson, Tulsa, Tempe, Syracuse, Omaha, Albuquerque, Knoxville, El Paso, Bakersfield, Allentown, Harrisburg, Scranton, Toledo, Baton Rouge, Youngstown, Springfield, Sarasota, Little Rock, Orlando, McAllen, Stockton, Charleston, Wichita, Mobile, Columbia, Colorado Springs, Fort Wayne, Daytona Beach, Lakeland, Johnson City, Lexington, Augusta, Melbourne, Lancaster, Chattanooga, Des Moines, Kalamazoo, Lansing, Modesto, Fort Myers, Jackson, Boise, Billings, Madison, Spokane, Montgomery, and Pensacola