Code Sec. 1031
* Sec. 1031 Issues: Exchange of property held for productive use or
investment -- Deferred exchanges.
ISSUE:
Whether Taxpayer is entitled to nonrecognition treatment under section
1031(a) of the Code with respect to his transfer of real property in a
multi-party exchange involving Taxpayer, a related party (Related Party),
an unrelated third party (UTP), and a qualified intermediary (QI)?
FACTS:
Prior to the transaction at issue, Taxpayer held Property X, a 1/3
interest in a parcel of unimproved land, for investment. Taxpayer's basis
in Property X was $a. Related Party, Taxpayer's mother, held Property Y, a
2/3 interest in the same parcel of unimproved land as Property X. Property
X's fair market value was $e.
UTP wanted to acquire the parcel of unimproved land consisting of
Property X and Property Y. On Date 1, Taxpayer and Related Party entered
into a Sale Agreement for the sale of Property X and Property Y to UTP. On
Date 2, Related Party purchased Property Z for $f, which she used as a
personal residence.
In early Year 1, after he had entered into the Sale Agreement with UTP,
Taxpayer decided that he wanted to do a like-kind exchange for other real
estate using the proceeds from the sale of Property X. Taxpayer initially
sought to acquire replacement real property from another unrelated third
party, but could not complete negotiations for the purchase of the
replacement real property he wanted in time for the exchange to qualify
under section 1031. On Date 3, after Taxpayer determined that acquisition
of this replacement property was unfeasible, he entered into the Purchase
and Sale Agreement with Related Party to acquire Property Z for $f.
On Date 4, Taxpayer, Related Party, UTP and QI engaged in an exchange
transaction which occurred in the following steps: First, Taxpayer
assigned and transferred all of his rights, title and interest in Property
X and his rights and obligations under the Sale Agreement with UTP to QI.
Second, Taxpayer assigned his rights and obligations under the Purchase
and Sale Agreement to acquire Property Z to QI. Third, in accordance with
the Sale Agreement, QI sold Property X to UTP for $e. Fourth, QI paid $e
(proceeds from the sale of Property X) to Related Party and Taxpayer paid
an additional $b directly to Related Party for Property Z. Fifth, Related
Party transferred Property Z, via QI, to Taxpayer. Separate from, but
concurrent with, the exchange transaction, UTP paid Related Party $g to
acquire Property Y.
After the exchange, Taxpayer held Property Z for investment, UTP owned
Property X, and Related Party had $f cash. It is assumed that QI is a
qualified intermediary as defined in section 1.1031(k)-1(g)(4)(iii) of the
Income Tax Regulations. Thus, if the exchange qualifies under section 1031
of the Code, Taxpayer recognizes no gain or loss from the transaction and
his new basis in Property Z is $c ($a + $b).
APPLICABLE LAW:
Section 1031(a)(1) of the Internal Revenue Code provides that no gain
or loss is recognized on the exchange of property held for productive use
in a trade or business or for investment if such property is exchanged
solely for property of like kind which is to be held either for productive
use in a trade or business or for investment.
Section 1031(d) of the Code provides that the basis of property
acquired in a like-kind exchange is the same as that of the property
exchanged, decreased by the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to
the taxpayer that was recognized on such exchange.
Section 1.1031(k)-1(g) of the regulations establishes various safe
harbors for deferred exchanges which result in a determination that the
taxpayer is not in actual or constructive receipt of money or other
property (not of like kind) for purposes of section 1031(a). One of the
safe harbors listed in paragraph (g) is that of the "qualified
intermediary."
Section 1.1031(k)-1(g)(4)(iii) of the regulations defines a qualified
intermediary as a person who (A) is not the taxpayer or a disqualified
person and (B) enters into a written agreement with the taxpayer (the
"exchange agreement") and, as required by the exchange agreement, acquires
the relinquished property from the taxpayer, transfers the relinquished
property, acquires the replacement property, and transfers the replacement
property to the taxpayer.
Section 1.1031(b)-2(a) of the regulations provides that in the case of
simultaneous transfers of like-kind properties involving qualified
intermediaries (as defined in section 1.1031(k)-1(g)(4)(iii)), the
qualified intermediary is not considered the agent of the taxpayer for
purposes of section 1031(a). In such a case, the transfer and receipt of
property by the taxpayer through a qualified intermediary is treated as an
exchange.
Section 1031(f)(1) of the Code provides that if a taxpayer exchanges
property with a related person, resulting in nonrecognition of gain or
loss under this section with respect to the exchange, and if within two
years of such exchange the related person or the taxpayer disposes of the
property received in the exchange, there is no nonrecognition of gain or
loss under section 1031 to the taxpayer with respect to such exchange. Any
gain or loss recognized by the taxpayer by reason of section 1031(f)(1) is
taken into account as of the date such latter disposition occurs.
Section 1031(f)(2) of the Code provides that for purposes of paragraph
(f)(1), there shall not be taken into account any disposition (A) after
the earlier of the death of the taxpayer or the death of the related
person, (B) in a compulsory or involuntary conversion (within the meaning
of section 1033) if the exchange occurred before the threat or imminence
of such conversion, or (C) with respect to which it is established to the
satisfaction of the Secretary that neither the exchange nor such
disposition had as one of its principal purposes the avoidance of Federal
income tax.
Section 1031(f)(3) of the Code provides that the term "related person"
means any person bearing a relationship to the taxpayer described in
section 267(b) or section 707(b)(1).
Section 1031(f)(4) of the Code provides that section 1031 shall not
apply to any exchange which is part of a transaction (or series of
transactions) structured to avoid the purposes of section 1031(f).
ANALYSIS:
The rationale for permitting taxpayers to defer gain or loss when they
exchange like-kind properties is the perception that such recognition is
inappropriate for taxpayers remaining invested in the same kind or class
of property. No "cashing out" of the investment has occurred. See H. R.
Rep. No. 101-247, 101st Cong., 1st Sess. 1340 (1989).
However, prior to the enactment of section 1031(f), a taxpayer could,
in effect, "cash out" its investment without recognizing gain by
structuring the disposition as a like-kind exchange with a related party.
By doing this, the taxpayer could shift high basis from the property the
taxpayer wished to retain to low basis property the taxpayer wished to
sell. The House Budget Committee Report accompanying the enactment of
section 1031(f) recognized that related parties have engaged in like-kind
exchanges of high basis property for low basis property in anticipation of
the sale of the low basis property. The exchange would then position the
parties to avoid or substantially reduce the recognition of gain on the
subsequent sale.
Section 1031(f) is thus intended to deny nonrecognition treatment for
transactions in which related parties make like-kind exchanges of high
basis property for low basis property in anticipation of the sale of the
low basis property. The committee determined that "if a related party
exchange is followed shortly thereafter by a disposition of the property,
the RELATED PARTIES have, in effect, 'cashed out' of the investment, and
the original exchange should not be accorded nonrecognition treatment." H.
R. Rep. No. 247, 101st Cong. 1st Sess. 1340 (1989) (emphasis added). The
committee thus treats the related parties in these transactions as a
single taxpayer, and the subsequent disposition of exchange property by
one related party as a "cashing out" by the other related party.
In this case, Taxpayer disposed of Property X through a qualified
intermediary QI and through the same qualified intermediary acquired
Property Z from Related Party. The economic result of this series of
transactions is identical to what would have occurred in a direct exchange
of Property X for Property Z between Taxpayer and Related Party, followed
by a sale of Property X by Related Party to UTP. In both cases and after
all steps are concluded, Taxpayer owns Property Z with a basis of $c,
Related Party has sale proceeds of $f (but no gain because of Related
Party's $f basis in Property Z), and UTP owns Property X. However, due to
the application of section 1031(f), Taxpayer would recognize gain of $d in
the case of the direct exchange.
Congress enacted section 1031(f)(4) to prevent related parties from
circumventing subsection (f)(1) through, among other means, the
structuring of transactions to involve unrelated parties. As an example,
the committee report states that "if a taxpayer, pursuant to a prearranged
plan, transfers property to an unrelated party who then exchanges the
property with a party related to the taxpayer within 2 years of the
previous transfer in a transaction otherwise qualifying under section
1031, the related party will not be entitled to nonrecognition treatment
under section 1031." H. R. Rep. No. 101-247 at 1341.
The deferred exchange regulations in section 1.1031(k)-1 provide for
the use of a qualified intermediary as one way to effect a like-kind
exchange. However, a qualified intermediary is not entitled to better
treatment than the unrelated party referred to in the House Budget
Committee Report. Thus, the mere interposition of a qualified intermediary
will not correct a transaction otherwise flawed under section 1031(f)(1).
Taxpayer argues that there was no tax avoidance motive to the exchange
because no such motive existed at the time that Taxpayer and Related Party
entered into the Sale Agreement with UTP. Taxpayer asserts that the fact
that Related Party did not own Property Z at the time that the Sale
Agreement was entered into and that there was no commitment or obligation
on his part to transfer Property X to Related Party is evidence of the
lack of tax avoidance motive in the exchange. However, nothing in the
statute or legislative history suggests that the only appropriate time for
determining the existence of a tax avoidance motive is the time that the
related parties first commit to sell the low basis property (Properties X
and Y). Nor does the example in House Budget Committee Report assume (and
thereby require for application of section 1031(f)(4)), as Taxpayer
argues, that there is a pre-arranged plan among the related parties and
the unrelated third party and a pre-existing commitment or understanding
at the inception of the arrangement that the related parties were going to
exchange their property interests.
Taxpayer also asserts that the fact that UTP, instead of Related Party,
could have acquired Property Z and exchanged this property with Taxpayer
for Property X under section 1031 is additional evidence of the lack of
Taxpayer's tax avoidance motive.
Taxpayer further argues that the transaction was initially structured
as an exchange with unrelated parties and therefore was not structured to
avoid the related party rules. Taxpayer initially sought to acquire
replacement real property from another unrelated third party, but was
unable to acquire the real property he wanted in time for the exchange to
qualify under section 1031. Only after Taxpayer failed to acquired
replacement property from an unrelated third party did he enter into the
Purchase and Sale Agreement with Related Party to acquire Property Z.
Thus, since the transaction was not "structured" to avoid the related
party rules, Taxpayer asserts that section 1031(f)(4) does not apply.
Taxpayer has offered no explanation for the use of the qualified
intermediary in this transaction. As noted above, the direct exchange of
Property X for Property Z, followed by the sale of Property X to UTP would
have been in violation of section 1031(f)(1) and would have caused
Taxpayer to recognize gain in the amount of $d. It is apparent that
Taxpayer and Related Party utilized a qualified intermediary for the sole
purpose of avoiding the related party rules of section 1031(f). It is this
aspect of the transaction's structure that manifests Taxpayer's intent to
avoid application of the related party rules. Moreover, the mere
possibility of the existence of alternative schemes (that would qualify
under section 1031(a)) to accomplish the same end result does not negate
Taxpayer's intention in undertaking the exchange that actually occurred.
Thus, Taxpayer's exchange of Property X for Property Z is part of a
transaction structured to avoid the purposes of section 1031(f) within the
meaning of section 1031(f)(4).
Section 1031(f)(2)(C) provides an exception to the disqualification of
a related party exchange for section 1031(a) nonrecognition treatment
under section 1031(f)(1). Although this exchange is not a related party
exchange because of the use of the qualified intermediary QI, Taxpayer
argues that the exchange did not have as one of its principal purposes the
avoidance of Federal income tax as provided in section 1031(f)(2)(C) and
therefore should qualify for nonrecognition treatment under section
1031(a) despite the application of section 1031(f)(4). However, in this
case there is no need to determine whether section 1031(f)(2)(C) is also
an exception to section 1031(f)(4), since Taxpayer has not established
that the exchange did not have as one of its principal purposes the
avoidance of Federal income tax.
Under these facts, Taxpayer has not demonstrated that use of the
qualified intermediary QI was not to avoid the purposes of the related
party rules of section 1031(f). Accordingly, pursuant to section
1031(f)(4), Taxpayer's exchange of Property X for Property Z with the
qualified intermediary QI is not eligible for nonrecognition treatment
under section 1031(a).
CONCLUSION:
Taxpayer is not entitled to nonrecognition treatment under section
1031(a) with respect to his transfer of Property X in a multi-party
exchange involving Taxpayer, a related party (Related Party), an unrelated
third party (UTP), and a qualified intermediary (QI).
* * * * *
A copy of this technical advice memorandum is to be given to Taxpayer.
Section 6110(j)(3) of the Code provides that it may not be used or cited
as precedent.
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