Do you know what June 29, 2019 is? Of course you do. It’s a Saturday. It’s also the 180th day of the period that began on January 1, 2019. Need another hint?
It is the final day by which a taxpayer who was an owner in a calendar-year pass-through entity – a partnership or S corporation –may elect to defer their share of any capital gain recognized by the pass-through entity during 2018 by contributing an amount equal to the amount of such gain to a qualified opportunity fund in exchange for an equity interest in the fund.
What’s more, it is the 74th day of the period that began on April 17, 2019 – the day on which the IRS issued its eagerly-awaited second set of proposed regulations related to the qualified opportunity zone (“QOZ”) rules.
Among the issues that were addressed in this second installment of guidance under Sec. 1400Z-2 of the Code was the ability of a taxpayer who already owns real property located in a QOZ to lease such property to a related person – say, a QOZ partnership – that would then improve the property and operate a qualifying business thereon. Significantly, the proposed regulations require that the terms of the lease must reflect arms-length market practice in the locale that includes the zone.
Anyone with any experience in tax matters is aware that transactions between related persons are generally subject to heightened scrutiny by the taxing authorities, lest the related persons structure a transaction to gain a tax advantage, without having a bona fide business purpose. Taxpayers have to be especially careful in situations for which the Code itself prescribes specific rules for dealings between related parties.
A recent decision[i] under the like-kind exchange[ii] rules – to which the QOZ rules are now often described as an alternative investment vehicle for deferring the recognition of otherwise taxable capital gain[iii] – should remind taxpayers of how vital it is to proceed with caution when transacting business with a related person.
Taxpayer was a business entity that owned real properties. It received a letter of intent from an unrelated third party offering to purchase one of Taxpayer’s commercial real properties (the “Property”). Among other things, the letter reserved to Taxpayer the right to effect an exchange of the Property as a like-kind exchange, and obligated the purchaser to cooperate toward that end. Taxpayer signed the letter of intent and, thereafter, began a search for suitable replacement property.[iv]
Taxpayer engaged a qualified intermediary (“Intermediary”) through which the Property would be exchanged.[v] Taxpayer thereupon assigned its rights under the letter to Intermediary, and transferred the Property to Intermediary, which sold the Property to the unrelated buyer for approximately $4.7 million. Taxpayer’s basis in the Property was approximately $2.7 million at the time of sale; a gain of approximately $2 million.
In order to meet the requirements for a tax-deferred like-kind exchange, Taxpayer had to identify replacement property within 45 days after the sale of the Property. Brokers presented numerous properties owned by unrelated parties as potential replacement properties, and Taxpayer attempted to negotiate the purchase of two of these properties, but was unsuccessful.
On the 45th day, Taxpayer identified three potential replacement properties, all belonging to RP, a business entity “related” to Taxpayer.[vi]
Intermediary purchased the identified real property owned by RP (“New Prop”) for approximately $5.5 million of cash, and transferred New Prop to Taxpayer as replacement property for the Property, as part of the like-kind exchange.
Taxpayer filed its income tax return[vii] in which it reported a realized gain of approximately $2 million from the sale of the Property, but deferred recognition of the gain pursuant to Section 1031 of the Code.[viii]
RP recognized over $3 million of gain from its taxable sale of New Prop, but it had sufficient net operating losses (“NOLs”) to fully offset such gain.
The IRS issued Taxpayer a notice of deficiency in which it determined that Taxpayer’s gain realized on the sale of the Property could not be deferred under Section 1031. Taxpayer filed a timely petition with the U.S. Tax Court.
Unfortunately for Taxpayer, the Tax Court agreed with the IRS.
The gain realized by a taxpayer from the conversion of property into cash, or from the exchange of property for other property differing materially in kind, is generally recognized by the taxpayer and included in their gross income.[ix]
In contrast, Section 1031(a) provides for the non-recognition of gain when property that is held by a taxpayer for productive use in a trade or business (or for investment) is exchanged for property of a like-kind which is likewise held by the taxpayer for productive use in a trade or business (or for investment).
The basis of the property acquired by a taxpayer in a Section 1031 exchange (the “replacement property”) is determined by reference to the basis of the property exchanged by the taxpayer (the “relinquished property”).[x] By preserving the taxpayer’s basis for the relinquished property – by making it the basis for the replacement property – the taxpayer’s gain is preserved for future recognition.[xi]
A non-simultaneous exchange, where the relinquished property is transferred before the replacement property is acquired, generally may qualify for non-recognition 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.[xii] A taxpayer may use a “qualified intermediary” (“QI”) to facilitate such a deferred exchange – wherein the QI acquires the relinquished property from the taxpayer, sells it, and uses the proceeds to acquire replacement property that it transfers to the taxpayer “in exchange for” the relinquished property – without the QI’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.[xiii]
In the case of a transfer of relinquished property involving a QI, the taxpayer’s transfer of relinquished property to a QI and subsequent receipt of like-kind replacement property from the QI is treated as an exchange with the QI.
Related Party Rules
Congress added Section 1031(f) to the Code in order to prevent certain abuses in the case of like-kind exchanges between related persons. According to the IRS, because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties were engaging in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. In this way, the related parties, as a unit, could reduce or avoid the recognition of gain on the subsequent sale.
For example, Taxpayer A owns Prop X with a FMV of $100 and basis of $10; Taxpayer B is related to A; B owns Prop Y with a FMV of $100 and a basis of $80; Props X and Y are like-kind to each other; an unrelated person wants to purchase Prop X; A and B swap Props X and Y in a like-kind exchange; Taxpayer B takes Prop X (B’s replacement property) with a basis equal to B’s basis in Prop Y (B’s relinquished property), or $80; B sells Prop X to the unrelated buyer and recognizes a gain of $100 minus $80, or $20; if A had sold Prop X directly to the buyer, A would have had gain of $100 minus $10, or $90; the A-B related party group saves a lot of taxes.
In general, Section 1031(f)(1) of the Code provides that if a taxpayer and a related person exchange like-kind property and, within two years, either one of the parties to the exchange disposes of the property received in the exchange, the non-recognition provisions of Section 1031(a) will not apply, and the gain realized on the exchange must be recognized as of the date of the disposition.[xiv]
Taxpayer and RP stipulated that they were related persons for purposes of this provision.[xv]
Section 1031(f) of the Code provides an exception to the “disallowance-upon disposition” rule for related parties. Specifically, it provides that 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, with respect to the disposition, “that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.”[xvi]
The Tax Court
The IRS did not dispute that Taxpayer’s exchange of the Property for New Prop met the requirements for a like-kind exchange. Furthermore, because Taxpayer used Intermediary to facilitate its sale of the Property and acquisition of the New Prop, the IRS did not contend that the exchange ran afoul of the specific requirements of section 1031(f). However, the IRS contended that Taxpayer’s exchange was disqualified from non-recognition treatment as a transaction structured to avoid the purposes of Section 1031(f) of the Code.
The Tax Court noted that the transaction at issue was the economic equivalent of a direct exchange of property between a taxpayer and a related person, followed by the related person’s sale of the relinquished property and their retention of the cash proceeds. In that case, the investment in the relinquished property had been cashed out, contrary to the purpose of Section 1031(f).
According to the Tax Court, the Taxpayer’s transaction was no different: The investment in the Property was cashed out with a related person’s (RP) retaining the cash proceeds. The interposition of a QI “could not obscure that result.”
Taxpayer: “No Intent to Avoid”
Taxpayer argued, however, that the exchange of the properties was not structured to avoid the purposes of Section 1031(f) because Taxpayer had no “prearranged plan” to conduct a deferred exchange with RP. Taxpayer contended that it had no prearranged plan because it first diligently sought a replacement property held by an unrelated party and only turned to New Prop when the deadline to complete a deferred exchange was imminent.
Taxpayer also emphasized that it decided to acquire the replacement property from a related person only after it had already engaged a QI (because a deferred exchange was necessary).
The Tax Court, however, found 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 Section 1031(f).[xvii]
The Results Say It All
According to the Tax Court, the inquiry into whether a transaction has been structured to avoid the purposes of Section 1031(f) is focused 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. Those actual consequences form the basis for an inference concerning whether the transaction was structured in violation of Section 1031(f).[xviii]
The Tax Court stated that it would infer a tax-avoidance purpose 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.
The Tax Court determined that Taxpayer would have had to recognize a $2 million gain had Taxpayer directly sold the Property to the unrelated third party. However, because the transaction was structured as a like-kind exchange, only RP was required to recognize gain, and that gain was almost entirely offset by its NOLs. The substantial economic benefits to Taxpayer as a result of structuring the transaction as a deferred exchange were thus clear: Taxpayer was able to cash out of the investment in the Property almost tax free. The Court thus inferred that Taxpayer 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.[xix]
It is true that RP recognized more gain on the disposition of New Prop than Taxpayer realized on the disposition of the Property. However, RP was able to offset the gain recognized with NOLs, resulting in net tax savings to Taxpayer and RP as an economic unit. 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 Property, Taxpayer and RP, viewed in the aggregate, “have, in effect, ‘cashed out’ of the investment”, virtually tax free – in contrast to the substantial tax liability Taxpayer would have incurred as a result of a direct sale to the unrelated buyer. Consequently, the transaction was “structured in contravention of Congress’s desire that non-recognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.”
Therefore, the Court concluded that the transaction was structured to avoid the purposes of Section 1031(f) and, consequently, Taxpayer was not entitled to defer recognition of the gain realized on the exchange of the Property under Section 1031(a)(1).
Taxpayer then appealed to the Ninth Circuit Court of Appeals.[xx]
Can You Say “Affirmed?”
The Court began its discussion by stating that, generally, “a taxpayer must pay taxes on gain realized on the sale or exchange of property. Section 1031 is an exception to this rule and is strictly construed.”
Under Section 1031(f), it continued, “a party may benefit from nonrecognition of the gain from an exchange of like-kind property with a related party . . . . However, any transaction or series of transactions structured to avoid the purposes of Section 1031(f) is ineligible for nonrecognition.”
The Court explained that the exchange at issue was structured for “tax avoidance purposes” because Taxpayer and RP “achieved far more advantageous tax consequences” by employing Intermediary to conduct the like-kind exchange than it would have had Taxpayer simply sold the Property to the third-party buyer itself. Had it done so, Taxpayer would have had to recognize approximately $2 million of gain. “Because the aggregate tax liability arising out of the exchange was significantly less than the hypothetical tax liability that would have arisen from a direct sale between the related parties, the like-kind exchange served tax avoidance purposes.”
Therefore, Taxpayer was not entitled to non-recognition of gain under Section 1031 of the Code.
Beware the Related Person
Especially when they come bearing gifts such as NOLs or high basis assets.
But seriously, a taxpayer should never be surprised when they are transacting with a related person. This warning applies most strongly to the owners of a closely held business and its affiliates, who are especially susceptible to engaging in such a transaction. They should know that the IRS will subject the transaction to close scrutiny.
The IRS will examine the transaction to ensure that it reflects a bona fide economic arrangement – in other words, that the related parties are dealing at arm’s-length with one another, and are not trying to achieve an improper tax result by manipulating the terms of the arrangement.
In other situations, such as the one described in this post, there are statutory and regulatory requirements and limitations of which the taxpayer must be aware when dealing with a related person. The disallowance or suspension of a loss, the conversion of capital gain into ordinary income, the denial of installment reporting – all these and more await the uninformed taxpayer.[xxi]
It is imperative that the taxpayer consult with their advisers prior to undertaking any transaction with any person with which or whom they have some relationship. The adviser should be able to determine whether the relationship is among those that the IRS views as worthy of closer look. The adviser should also be able to inform the taxpayer whether the relationship comes within any of the applicable anti-abuse or other special rules prescribed by the Code or the IRS.
In this way, the taxpayer can plan accordingly, and without surprises.
[i] The Malulani Group, Limited v. Comm’r, No. 16-73959 (9th Cir. 2019).
[ii] IRC Sec. 1031.
[iii] https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-i/ and https://www.taxlawforchb.com/2019/04/deferring-real-property-gain-like-kind-exchange-or-opportunity-fund-part-ii/
[iv] The search should always begin as far in advance of the sale as is reasonably possible.
[v] As part of a deferred exchange.
[vi] Many taxpayers will identify a Delaware Statutory Trust as their final choice of replacement property – in case they cannot acquire one of their “preferred” replacement properties – simply to avoid the recognition of gain from the sale of the relinquished property.
[viii] Kris: upper case “C”.
[ix] Reg. Sec. 1.1001-1.
[x] IRC Sec. 1031(d).
[xi] Taxpayer A owns Prop X with a FMV of $100 and a basis of $20 (built-in gain of $80); A exchanges Prop X for Taxpayer B’s like-kind Prop Y, which has a FMV of $100; A takes Prop Y with a basis of $20, thereby preserving the $80 of gain.
[xii] IRC Sec. 1031(a)(3).
[xiii] Reg. Sec. 1.1031(k)-1(g)(4)(i).
[xiv] Although Section 1031(f)(1) disallows non-recognition treatment only for direct exchanges between related persons, Section 1031(f)(4) provides that non-recognition treatment does not apply to any exchange which is part of a transaction or series of transactions “structured to avoid the purposes of” Section 1031(f). Therefore, Section 1031(f)(4) may disallow non-recognition treatment of a deferred exchange that only indirectly involves related persons because of the interposition of a QI.
[xvi] Any inquiry under IRC Sec. 1031(f)(4) as to whether a transaction is structured to avoid the purposes of section 1031(f) also takes into consideration the “non-tax-avoidance exception” in Sec. 1031(f)(2)(C).
[xvii] Because the absence of a prearranged plan was not dispositive regarding a violation of IRC Sec. 1031(f)(4), the Court did not believe it was material that Taxpayer engaged a QI before deciding to acquire New Prop from RP.
[xviii] In other words, one must compare the hypothetical tax that would have been paid if the 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 party in a like-kind exchange followed by the related party’s sale of the relinquished property. For this purpose, the actual tax paid comprised the tax liability of both the taxpayer and the related in the aggregate.
[xix] As in the example, above.
[xx] IRC Sec. 7482.
[xxi] For example, IRC Sections 267, 453, 707 and 1239.