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