Exchanges, In General

A taxpayer must recognize the gain realized by the taxpayer from the conversion of a property into cash, or from the exchange of the property for other property differing materially in kind.

Under an exception to this general recognition rule, gain is not required to be recognized if property that is held by the taxpayer for productive use in a trade or business, or for investment, is exchanged by the taxpayer solely for property of a like-kind to be held either for productive use in a trade or business or for investment.

However, even an otherwise qualifying like kind exchange may be adversely impacted where the parties to the transaction are “related” to one another. Such a result is most likely to occur within a group of closely held business entities, as was illustrated in a recent decision of the U.S. Tax Court.

A Related Company Exchange?

Commercial Real Estate LeaseTaxpayer was a consolidated group of corporations consisting of Parent and its wholly-owned subsidiary (“Sub”). During the years at issue, Taxpayer’s operations consisted of leasing commercial real estate throughout the country.

Parent also owned 70% of the common shares of Affiliate, another corporation that owned real estate. Each company had a separate board of directors and a different president. However, Mr. Big served as president of Parent and as CEO of Sub during all relevant years.

Parent had made substantial loans to Affiliate. Decisions concerning the loans were made by a committee of Parent’s board established for that purpose. The committee’s role was to assess Affiliate’s financial condition and to determine how much would be lent. The committee was composed of Mr. Big and two other individuals.

Sub received a letter of intent from an unrelated third party offering to purchase the Relinquished Property. The letter outlined the anticipated terms for a purchase agreement covering the Relinquished Property. It reserved to Sub the right to effect an exchange of the property under Section 1031 of the Code (a “like-kind exchange”) and obligated the third party purchaser to cooperate toward that end. Sub’s representative signed the letter of intent and, thereafter, Parent and Sub began a search for suitable replacement property with the aid of real estate brokers.

Sub engaged Qualified Intermediary (“QI”) to serve as an intermediary through which the Relinquished Property could be exchanged, and entered into an exchange agreement with QI setting forth the terms under which QI would serve as an intermediary. Sub thereupon assigned its rights under the letter of intent to QI and subsequently transferred the Relinquished Property to QI. QI sold the Relinquished Property to the third party.

In order to meet the requirements of a “tax-free” like-kind exchange, Sub had to identify replacement property within 45 days after the sale of the Relinquished Property. As of the sale date of the Relinquished Property, neither Parent nor Sub had considered acquiring a replacement property from Affiliate or any other related party. The brokers presented numerous properties owned by unrelated parties to the Parent and Sub as potential replacement properties, and Sub attempted, unsuccessfully, to negotiate the purchase of some of these properties for that purpose. However, just before the identification period expired, in an attempt to preserve the like-kind exchange, Sub identified three potential replacement properties, all belonging to Affiliate.

QI timely purchased one of these real properties owned by Affiliate (the “Replacement Property”) and transferred it to Sub as replacement property for the Relinquished Property.

Like-Kind Exchanges

Taxpayer timely filed a consolidated Form 1120, U.S. Corporation Income Tax Return, on which Taxpayer reported a realized gain from the sale of the Relinquished Property but deferred recognition of the gain pursuant to Section 1031. Taxpayer also reported an unrelated net operating loss (“NOL”).

Affiliate recognized gain on its tax return from the sale of the Replacement Property, which would have increased its regular income tax liability by a significant amount. However, Affiliate had sufficient NOLs to fully offset its regular tax liability relating to the sale.

The IRS determined that the gain realized by Taxpayer on the sale of the Relinquished Property did not qualify for Section 1031 deferred recognition.

Section 1031 of the Code allows nonrecognition of gain on the exchange of property held for productive use in a trade or business, or for investment, when the property is exchanged for property of a like-kind.

As a nonrecognition provision, Section 1031 merely defers recognition of the gain inherent in the property sold – it does not eliminate it. This deferred gain is preserved for recognition by Taxpayer upon a later taxable disposition of the like-kind property acquired. This is accomplished by requiring that the basis of the property acquired in the Section 1031 exchange (the replacement property) be the same as the basis of the property exchanged (the relinquished property).

Deferred Exchanges

In most cases, a taxpayer disposing of property will not be able to find a buyer who owns like-kind property that the buyer is willing to exchange, and that the taxpayer wants to acquire (a “simultaneous exchange”). In recognition of this reality, Congress and the IRS provided special rules for non-simultaneous exchanges. Unfortunately, because of very strict statutory requirements, these rules are often not as helpful as most taxpayers would like.

A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for nonrecognition of gain if the taxpayer identifies the replacement property, and then receives it, within 45 days and 180 days, respectively, of the transfer of the relinquished property. These identification and acquisition periods cannot be extended.

A taxpayer may use a qualified intermediary to facilitate such a deferred exchange – wherein the intermediary acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer – without the intermediary’s being treated as the taxpayer’s agent or the taxpayer’s being treated as in constructive receipt of the sales proceeds from the relinquished property.

In the case of a transfer of relinquished property involving a qualified intermediary, the taxpayer’s transfer of relinquished property to a qualified intermediary and the subsequent receipt of like-kind replacement property from the qualified intermediary is treated as an exchange with the qualified intermediary.

The Related Party Rules

In order to prevent certain perceived abuses, Congress enacted a special rule to limit nonrecognition treatment in the case of like-kind exchanges between certain related persons. This rule generally provides that if a taxpayer and a “related person” exchange like-kind property and, within two years, either one of them disposes of the property received in the exchange (i.e., “cashes out” the investment), the nonrecognition provisions will not apply, and the gain realized must be recognized as of the date of the disposition.

The anti-abuse rule applies to direct simultaneous exchanges between related persons, and to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” the rule. Therefore, it may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of a qualified intermediary.

However, under an exception to the disallowance-upon-disposition rule, any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”

The Tax Court’s Analysis

The parties stipulated that Parent, Sub, and Affiliate were “related persons” within the meaning of the rule.

The IRS did not dispute that Sub’s exchange of the Relinquished Property for the Replacement Property met the requirements for a like-kind exchange. Furthermore, because Sub used QI, a qualified intermediary, to facilitate its sale of the Relinquished Property and acquisition of the Replacement Property, the IRS did not contend that the exchange ran afoul of the specific requirements for like-kind exchange treatment.

However, the IRS contended that Sub’s exchange was disqualified from nonrecognition treatment pursuant to the related party rule because QI had sold the relinquished property to Affiliate for cash as part of the exchange transaction (an “indirect” transfer between related parties).

The Court noted that, in earlier cases in which had considered taxpayers who had received replacement property from related persons in deferred exchanges involving qualified intermediaries, followed by the related persons’ sales of the relinquished property, it had concluded that the transactions were the economic equivalent of direct exchanges of property between the taxpayer and the related person, followed by the related person’s sale of the relinquished property and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purpose of the related party rule.

The transaction at issue, the Court stated, was no different: The investment in the Relinquished Property was cashed out with a related person’s (Affiliate’s) retaining the cash proceeds. The interposition of a qualified intermediary could not obscure that result.

Taxpayer, however, argued that the exchange of the Relinquished and Replacement Properties was not structured to avoid the purposes of the related person rule because Sub had no “prearranged plan” to conduct a deferred exchange with Affiliate. Taxpayer argued that, initially, Sub diligently sought a replacement property held by an unrelated party, and only turned to the Replacement Property when the deadline to complete a deferred exchange was imminent.

The Court rejected this argument, stating that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange was not dispositive of a violation of the rule.

Instead, the inquiry into whether a transaction had been structured to avoid the rule should focus, the Court said, on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. According to the Court, those actual consequences form the basis for an inference concerning whether a transaction was structured in violation of the rule.

The Court in compared the hypothetical tax that would have been paid if a taxpayer had sold the relinquished property directly to a third party with the actual tax paid as a result of the taxpayer’s transfer of the relinquished property to the related person in a like-kind exchange followed by the related person’s sale of the relinquished property. For this purpose the actual tax paid comprised the tax liability of both the taxpayer and the related person in the aggregate.

Where the aggregate tax liability of the taxpayer and the related person arising from their like-kind exchange and sale transaction is significantly less than the hypothetical tax that would have arisen from the taxpayer’s direct sale of the relinquished property, it may be inferred that the taxpayer structured the transaction with a tax-avoidance purpose.

The Court’s Conclusion

Taxpayer would have had to recognize a significant gain had Sub directly sold the Relinquished Property to an unrelated third party. Although Taxpayer’s NOLs would have offset a portion of this gain, it would have paid additional tax as a result of the direct sale.

However, because the transaction was structured as a like-kind exchange, only Affiliate was required to recognize gain – and that gain was almost entirely offset by its NOLs.

The substantial economic benefits to Taxpayer and Affiliate as a result of structuring the transaction as a deferred exchange were thus clear: Parent and Sub were able to cash out of the investment in the Relinquished Property almost tax-free. The Court thus inferred that Sub had structured the transaction with a tax-avoidance purpose.

Taxpayer argued that the transaction nonetheless lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high basis property. Although it was true that Affiliate recognized more gain on the disposition of the Replacement Property than Sub realized on the disposition of the Relinquished Property, Affiliate was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and Affiliate as an economic unit. The Court stated that net tax savings achieved through use of the related party’s NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting.

In sum, by employing a deferred Section 1031 exchange transaction to dispose of the Relinquished Property, Taxpayer and Affiliate, viewed in the aggregate, effectively “cashed out” of the investment, virtually tax free – in stark contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale.

Moreover, Taxpayer failed to demonstrate that avoidance of Federal income tax was not one of the principal purposes of Sub’s exchange with Affiliate and the disposition of the Relinquished Property.

The Court, therefore, concluded that the transaction was structured to avoid the purposes of the related person rule. The transaction was structured in contravention of Congress’s desire that nonrecognition treatment only apply to transactions “where a taxpayer can be viewed as merely continuing his investment.” Consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Relinquished Property under the like-kind exchange rules.

Keep In Mind

The foregoing illustrates only one of the pitfalls of which a seller of property must be aware when dealing with a related party buyer.  There are many others. Any sale or exchange that may involve a related party should be examined closely to account for potential tax consequences. Once the tax and the business issues have been identified, and the resulting economic consequences have been considered, the taxpayer can plan accordingly.