Section 1031 Like-Kind Exchanges Todd D. Keator Thompson & Knight LLP [email protected] August 27, 2014.

Section 1031 Like-Kind Exchanges

Todd D. Keator Thompson & Knight [email protected]

August 27, 2014

Introduction

• Background• Operation of § 1031• Forward Exchanges• Reverse Exchanges• Related Party Issues

2

Background • General Rule – Gain or loss recognized upon a

sale or exchange of property. § 1001.• Individuals: Current LTCG tax rate is 20.0%, plus

possible 3.8% additional “NII” tax. • Corporations: 35%.

• Exception – Since 1924, no gain or loss recognized if disposition structured as a “1031 exchange” for “like kind” property.

• Purpose – Congress did not want to impose a tax on theoretical gain where taxpayer continued his investment in like kind property.

3

2-Party vs. 4-Party• A 2-party exchange is the most classic form of a

1031 transaction (a simultaneous transfer).– Example: Bill owns Whiteacre valued at $100. Sam

owns Blackacre valued at $100. Bill and Same exchange Whiteacre and Blackacre.

• Today, the more common form is a 4-party transaction among the taxpayer, a buyer, a seller, and a “qualified intermediary” who stands in the middle. This transaction may span up to 180 days.

4

Excluded Property

• Key exclusions: no stock, partnership interests, certificates of trust, or “dealer” property. – No partnership or LLC interests! [Be careful with

tenancy-in-common interests.]– Oil and gas tax partnerships must elect out of

subchapter K prior to a 1031 exchange. – No buying and “flipping” inventory.

• Special rules for related parties (1031(f)). 5

“Boot”• Boot: taxpayer allowed to receive cash

“boot” in the exchange, but boot is taxable to the extent of gain realized.

• Liability relief also considered boot, but may be offset by liabilities assumed in the exchange or cash paid in the exchange.

• Boot always recognized first without any basis offset. – Generally taxable as recapture first, then as

capital gain or 1231 gain. 6

Example

• Taxpayer exchanges Relinquished Land worth $100 ($60 AB) for Replacement Land worth $80 plus $20 cash. The $20 of cash is “boot” and is taxable first to the extent of Taxpayer’s gain realized (i.e., all $20 is taxable because gain realized is $40).

• If the cash boot instead were $50, Taxpayer would recognize only $40 of boot gain (i.e., only to the extent gain is realized).

7

Example

• Taxpayer exchanges Relinquished Land worth $100 ($30 AB), and subject to $20 of debt, for Replacement Land worth $100, and also subject to $20 of debt. The $20 of “debt relief” boot is offset by $20 of replacement liabilities, resulting in no boot gain.

• If the Replacement Land instead was worth $90 and was subject to $10 of debt, Taxpayer would recognize $10 of debt boot gain.

8

Basis • Basis: generally, basis in relinquished property rolls

over into replacement property, with certain adjustments.

• MACRS – the default MACRS Treatment for replacement property is to “step into the shoes” of the relinquished property. Treas. Reg. 1.168(i)-6.

• Disadvantages:– Higher gain on sale of replacement property;– Lower depreciation deductions going forward.

9

Example

• Taxpayer exchanges Relinquished Land (FMV $100; AB $30) for Replacement Land (FMV $100). Taxpayer’s $30 basis rolls over and becomes Taxpayer’s basis in Whiteacre too.

• Same, but now Replacement Land has a FMV of $120, so Taxpayer equalizes the transaction by paying additional $20 cash at closing. Now, Taxpayer’s AB in Replacement Land is $50 ($30 rolls over, plus $20 excess cash).

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Key Elements of § 1031

• § 1031(a) provides: “No gain or loss shall be 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.”

• 3 prongs of the general rule:– There must be an “exchange.”– The exchanged properties must be “held for” productive

use in trade or business or investment (“held for” test).– The exchanged properties must be of “like kind.”

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Meaning of “Exchange” • Reciprocal transfer of property.• Sale and immediate reinvestment of cash does not

qualify – can’t touch the cash!• No requirement that exchange be simultaneous; forward

and reverse exchanges are allowed (and are normal).• Cannot start a 1031 exchange with a lease (but oil & gas

leases are different). Pembroke v. Helvering, 23 B.T.A. 1176 (1931) (99-year lease).

• Oil & gas: Beware retained overriding royalty! (converts “sale” or “exchange” into a “lease”).

12

Examples• TP grants a 99-year lease of Blackacre to Tenant

in exchange for the Tenant’s promise to pay annual rent and to transfer to the TP a fee interest in Whiteacre. This is a lease, not an exchange, so the TP’s receipt of Whiteacre is taxable as pre-paid rent.

• Taxpayer sells Relinquished Land for $100, and one minute later purchases Replacement Land for $100. This is a sale followed by a purchase, and does not qualify as a 1031 “exchange”.

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• “Drillco” negotiates a deal to sell a 75% working interest to Buyer for (A) $100,000,000 and (B) retention of an overriding royalty (an “ORRI”) equal to 25% less all landowner royalties on the leases (e.g., on leases burdened by a 20% landowner royalty, the ORRI will be 5%). Is the transaction eligible for a 1031 exchange?

14

BuyerDrillCo.

10,000 Acres

75% Working Interest

75% Working Interest

$100,000,000

Retained ORRI

Authorities• The answer is determined on a lease-by-lease basis. See

Cullen v. Comm’r, 118 F.2d 651 (5th Cir. 1941) (whether a sale or lease occurs must be determined on a property-by-property basis).

• The answer is no for any leases upon which DrillCo retains an ORRI. – See Crooks v. Comm’r, 92 T.C. 816 (1989) (retention of a royalty

in the “sale” of mineral interests converts the transaction into a lease for federal income tax purposes; Section 1031 is not available); Rev. Rul. 69-352.

• The answer is yes for leases upon which DrillCo does not retain an ORRI.

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Solutions?• Can DrillCo change the business deal and fix the

problem? • Probably so. Some possibilities are:

– Don’t retain an ORRI and instead ask for more cash or other consideration.

– Sell a smaller working interest for the same cash payment. – Re-define the retained “ORRI” so that it is not a “royalty”

for federal income tax purposes (e.g., use a term shorter than the expected life of the burdened properties). What impact does this have on the Buyer? See Cullen and PLR 9437006 (re. retained production payments).

– Carve off the ORRI and convey it to a separate but related taxpayer ahead of closing?

16

The “Held For” Requirement • Both “relinquished property” and “replacement

property” must be held for productive use in a trade or business or for investment.

• Intent determined at time of the exchange. • Generally covers all property used in a trade or

business and all property held for investment, but excludes dealer property (e.g. home lots) and personal use property (e.g. vacation homes, unless safe harbor met).

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Satisfying the “Held For” Requirement • Test is intent at the time of the exchange; prior

bad intent may be converted to good.• No bright line tests for holding period of

relinquished or replacement property.– One year is a good rule of thumb; two years is more

conservative.

• Same taxpayer must start and complete the 1031 exchange (discussed in greater detail later).

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Recent Cases re. Homes• Yates v. Comm’r, TC Memo 2013-28: TPs acquired purported

“bed and breakfast” in 1031 exchange but immediately used it as a personal residence; 1031 failed.

• Goolsby v. Comm’r, TC Memo 2010-64: TPs acquired purported rental property, made minimal attempts to rent it, and moved in as personal residence two months later; 1031 failed.

• Reesink v. Comm’r, TC Memo 2012-118: TPs acquired purported rental property, made bona fide efforts to rent the property, but ultimately moved in 8 months later; 1031 sustained. Factors: TPs placed flyers and showed the property to renters.

• Adams v. Comm’r, TC Memo 2013-7: TP’s purchase of house rented to his son with proceeds from sale of other rental property qualified as a 1031 exchange; intent to rent to son was investment intent; son paid rent of $1200 per month.

19

20

Vacation Homes• Moore v. Commissioner, T.C. Memo 2007-134: TP exchanged

one vacation home for another. Neither home was rented; both were used only for personal purposes. TP claimed “investment” intent. Court held properties held for personal use; 1031 failed.

• Rev. Proc. 2008-16 – Vacation Properties– “Dwelling unit” must pass “qualifying use” test– “Qualifying use” generally means:

• Owned by TP for at least 24 months before (for RLP) or after (for RPP) the exchange

• For each 12 month period, TP must rent dwelling unit to a 3P at fair rental value for 14 days or more

• TP’s personal use cannot exceed greater of (i) 14 days or (ii) 10% of number of days dwelling unit is rented to 3Ps

» 33 days maximum if TP rented for 332 days

“Held For” Requirement “Drop & Swap” Solution

• Potential solution to exclusion of exchanges of partnership interests.

• Prior to exchange, partnership “drops” undivided interests in property to exchange partners. Afterwards, exchange partners “swap” pursuant to § 1031.

• Issue: Did exchange partners satisfy the “held for” requirement with respect to the relinquished property?

• The Tax Court and 9th Circuit have ruled in favor of TPs on this issue, but the IRS continues to challenge these transactions (e.g., recent amendment to Form 1065, Schedule B).

• May also be challenged under Court Holding doctrine.

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Meaning of “Like Kind” Real Property

• Broadly defined:– “The words ‘like kind’ have reference to the nature or

character of the property and not to its grade or quality. . . . The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.”

• Any real property usually qualifies. • By statute, foreign and domestic properties are

never of “like kind.” • Disregarded entities are “disregarded.”

• Oil and gas royalty trusts???

22

Examples of “Like Kind” Real Property

• A 25,000 acre farm for the Empire State Building;

• A 30-year+ lease of real property for a fee interest in real property;

• Perpetual water rights for an easement; • Mineral properties for a hotel; and• Working interests in two leases;

23

VIP Industries v. Comm’r, TC Memo 2013-157

• TP exchanged ground lease with 21 years remaining + motel improvements (that TP built) for fee interest in motel and office building; court held 1031 failed because 21-year ground lease is not like kind to fee interest. Also, motel improvements could not separately qualify because they were of a short term nature and reverted to lessor on expiration of lease. Thus, “short term real property” interest is not of like kind to a fee interest.

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Meaning of “Like Kind” Personal Property and Intangibles

• Personal property, intangibles, and equipment are not like kind to real property, but might be like kind to other personal property and equipment acquired in the exchange.

• The rules governing what types of personal property are considered like-kind are much more specific than the rules that apply to real property.

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Meaning of “Like Kind” Personal Property and Intangibles, cont’d.

• To qualify for exchange treatment, the Relinquished and Replacement Properties must be either “like-kind” or “like-class.” – “Like-kind” refers to assets that have the same “nature and

character,” such as an airplane exchanged for an airplane, or a backhoe exchanged for a backhoe.

– “Like-class” refers to tangible, depreciable personal property that falls within the same General Asset Class or within the same Product Class, sharing the same 6-digit NAICS code. Treas. Reg. §1.1031(a)-2. The Product Classes are found in Sectors 31 through 33 of the North American Industry Classification System (NAICS).

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Personal Property and IntangiblesExamples of “Like Kind”

• Personal computer for a printer; grader for a scraper; sanding machine for a lathe. T.R. Sec. 1.1031(a)-2(a)(7).

• Steer calves for Aberdeen Angus livestock (Wylie v. U.S., 281 F. Supp. 180 (N.D. Tex 1968).

• Passenger vans and SUVs for cars (PLR 200450005). • Not like kind:

– Airplane for heavy general purpose truck. T.R. Sec. 1.1031(a)-2(a)(7). – Gold bullion and silver bullion (Rev. Rul. 82-166)– Light duty truck for a car (PLR 200240049). – Lithographs for oil paintings and watercolors (PLR 8127089).

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Intangible Examples, Cont’d• Intangibles:

– The exchange of a LA radio station for 3 St. Louis radio stations qualified for 1031. See Deseret Management Corp. v. U.S., 11 AFTR 2d 2013-530 (respecting purchase price allocation).

– Major league sports contracts (Rev. Ruls. 71-123; 71-137).

– Airport slots at different airports. GCM 39606.• Goodwill is specifically excluded. T.R. Sec.

1.1031(a)-2(c)(2).

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Classifying Property as Real or Personal

• Generally, state law determines whether property is real or personal.

• Fixtures are regarded as real property in most states, however, the treatment of some types of property are not consistent.

• In some instances, the IRS has ruled whether the item is real or personal property for 1031 exchange purposes, overriding state law classifications.

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Classifying Property as Real or Personal- Example

• The Red River Shootout:– In Texas, pipelines are real property if they are buried. – In Oklahoma, pipelines are personal property.

• Can a pipeline in TX be “like kind” to a pipeline in OK?

• IRS has alleviated the conflict in state law by ruling that pipelines are real property for 1031 exchange purposes, regardless of the state law classification. ILM 20123807

30

Real World Example• Can gas gathering lines and a gas processing plant

located in Louisiana be of like kind? Analysis:– Personal property under state law? [Yes.] – Must be of “like kind” or “like class”

• Like kind? Maybe, but no guidance on point. Same “nature and character”?

– Both contain pipes, tubing, pumps, compressors and move raw gas to market.

• Like class? Both described in NAICS product code 237120 (listing “gathering line” and “gas processing plant,” but this is outside sectors 31-33.

– But, LAFA 20072101F says still relevant for “like kind” determination.

31

32

“99-6” Rulings

• PLR 200807005

TP QI LP

Replacement Property

100% LP Interests

P1P2 P3

100% LP In

tere

sts

• Based on Sit. 2 of Rev. Rul. 99-6

33

“99-6” Rulings

• PLR 200909008

EAT LP

50% LP

Inte

rest

TP

(day

180)

50% 50%

Partner

50% LP Interest(day 1)

Replacement Property

• Based on Sit. 1 of Rev. Rul. 99-6

Typical Exchange Structures• “Forward” Exchanges are products of IRC 1031(a)

(3) and generally use a “Qualified Intermediary” (and sometimes a “qualified trust” or “qualified escrow”).

• “Reverse” Exchanges have no Code authority and rely on safe harbor Rev. Proc. 2000-37, generally using an “Exchange Accommodation Titleholder” or EAT.

• 45-day “identification” and 180-day closing required.

34

Forward Exchanges• A non-simultaneous exchange whereby TP disposes of

relinquished property first, and acquires replacement property at a subsequent date.

• May be a 2-party exchange, but generally is a 4-party exchange involving (1) TP, (2) Qualified Intermediary (“QI”), (3) Buyer of TP’s relinquished property, and (4) Seller of TP’s replacement property.

• QI cannot be a “disqualified person” (including a related party). See Blangiardo v. Comm’r, TC Memo 2014-110 (1031 failed because TP’s son (a lawyer) attempted to act as QI for TP’s exchange).

35

Requirements for a Forward Exchange

• TP must identify the replacement property(ies) within 45 days after transfer of relinquished property.

• TP must acquire the replacement property(ies) by the earlier of (i) 180 days after transfer of relinquished property, or (ii) the due date (with extensions) for the TP’s tax return for the year in which TP transferred the relinquished property. Generally, 180-day limit applies.

• TP must not be in actual or constructive receipt of cash during this time.

• These are hard deadlines.

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“Identification” of Replacement Property • Identification must be made in writing within the 45-day

period. • Identification is limited to:

– 3 properties (without regard to the FMV) OR – Any number of properties so long as aggregate FMV does

not exceed 200% of FMV of the relinquished property. – There is also safety valve 95% rule

• Must specifically identify replacement property.• Replacement property must be “substantially the same

property” as was identified.

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Real-World Example• TP properly identifies in writing certain 100-ton

“coal gondola railcars,” each with 4,400 cubic foot capacity, manufactured by X in 1998 as replacement property for a 1031 exchange. However, to complete the exchange, TP ultimately acquired identical coal gondola railcars manufactured by Y in 2000 (having the same weight, dimensions, and capacity). Did TP acquire “substantially the same” railcars as were identified?

38

Typical 4-Party Forward Exchange Example

• TP owns Blackacre and desires to acquire Whiteacre from Sarah Seller. However, Sarah Seller wants to sell Whiteacre for cash, not Blackacre. Bill Buyer, however, desires to acquire Blackacre, and is willing to pay cash for it. TP engages QI to facilitate the transaction as follows: Day 1: TP transfers Blackacre to QI, and QI sells Blackacre to Bill Buyer for cash. Day 2: QI uses the cash to purchase Whiteacre from Sarah Seller. Day 3: QI transfers Whiteacre to TP to complete TP’s 1031 exchange.

39

Example 3 – Typical 4-Party Forward Exchange

QI

TP

Blackacre

(6) Whiteacre

(1) Blackacre

Seller - Whiteacre

Buyer - $

(5) White

acre

(4) $

(3) $(2) Blackacre

40

Reverse Exchanges • Similar to a forward exchange, but the order is reversed.• Typical example: TP desires to exchange Blackacre and acquire

Whiteacre as replacement property in a 1031 exchange. Whiteacre is placed on the market prior to the time TP is able to find a buyer for Blackacre, so not wanting to miss his chance, TP instructs a third party to acquire Blackacre for cash (funded by TP). Once TP finds a buyer for Blackacre, TP arranges through a QI to sell Blackacre to the buyer, and then QI uses the cash to purchase Whiteacre from TP’s third party, and then QI transfers Whiteacre to TP to complete the 1031 exchange. Third party repays the cash to TP.

• Issue: If the third party is TP’s agent or nominee, then the TP has exchanged with himself, which does not qualify under § 1031.

41

Reverse Exchange Safe Harbor • The IRS issued a safe harbor Rev Proc 2000-37 pursuant to

which taxpayers may safely engage in reverse 1031 exchanges.

• Basic requirements: taxpayer and the EAT must enter into a written QEAA Agreement; if the replacement property is parked, taxpayer must properly identify the relinquished property in the same manner as described for forward exchanges; taxpayer must complete the entire transaction within 180 days; EAT must report itself as tax owner of the property it holds during the QEAA period.

• Benefits: TP can safely loan money to the EAT to acquire the replacement property to be parked, or TP can guaranty loans to the EAT for such purpose. TP can lease the replacement property from the EAT pending completion of the exchange for no rent. TP can manage the replacement property during such period.

42

Reverse Exchange Safe Harbor – Diagram

EAT

TP

Blackacre

(1) Loan $

(4) Blackacre

(7) Whiteacre

(8) Repay loan $

Seller - Whiteacre

Buyer - $

(2) $

(3) White

acre

(6) $(5) Blackacre

43

Role of Entities in Exchanges - Same Taxpayer Rule

• The same taxpayer that disposed of relinquished property must acquire replacement property– Not explicitly stated in section 1031, but derived

from section 1031(a)(3)– Applies to Individuals, Partnerships, Corporations,

and Trusts. – Does not apply to Disregarded entities or Qsubs.

44

Same Taxpayer Rule Individuals

• If relinquished property was held at community or separate property, replacement property should be held as community or separate property. TAM 8429004.

• If taxpayer dies during exchange period, exchange may be completed by estate. Rev. Rul. 64-161.

45

Same Taxpayer Rule –Partnerships

• Same partnership which sells relinquished property must acquire replacement property. TAM 9227022.

• Conversion from a GP to LP or LLC should not affect exchange. PLR 99935065.

• A change in ownership may occur during the exchange period as long as partnership does not terminate– However, no guidance on IRC 708(b)(1) terminations

• Notably, partners in a partnership cannot complete an exchange started by the partnership.

46

Same Taxpayer Rule Corporations

• If corporation owned relinquished property, corporation (not shareholders) must acquire replacement property

• If a corporation undergoes a tax-free reorganization, successor corporation may acquire replacement. TAM 9252001, PLR 200151017.

• Changes in stock ownership should not affect exchange

• Consolidated group members?

47

PLR 201024036

Parent

Subsidiary

Step (1) Sub distributes NOx Credits to Parent

Third Party

Step (2) Parent exchanges NOx Credits for VOCs Credits

NOx

VOCs

48

PLR 201024036• Rev. Proc. 92-91: Emission allowances are

treated as “like kind” under 1031.• NOx and VOCs treated as government licenses

or permits and intangible property for federal tax purposes.

• IRS ruled NOx and VOCs credits were of “like kind.”

• Parent considered to have, prior to the exchange, held the NOx credits for productive use in a trade or business.

49

Same Taxpayer Rule Grantor Trusts

• Exchanges of trust interests are disqualified under section 1031(a)(2)(E)

• However, the IRS has softened this position over the years. – In Rev. Rul. 92-105, the IRS ruled that a beneficial interest

in an Illinois land trust is real property for 1031 exchange purposes.

– IRS later expanded this ruling to permit grantor trusts to engage in 1031 exchanges in Rev. Rul. 2004-86.

• Royalty trusts? Prohibited trust interest or security?

50

Related Party ExchangesGeneral Rules of § 1031(f)

• Related Party Exchanges are permitted under 1031, but are subject to several restrictions.

• Each related party must hold replacement property 2 years after exchange or both transfers are taxed.– 2 year test is a bright line test.

• On disqualifying disposition, tax incurred by both in year of disposition

• Anti-abuse provision hits indirect transactions: § 1031(f)(4)

51

• Purpose of 1031(f): to prevent abusive basis shifting.

• Example. Assume A and B are father/son:

Introduction

Skyscraper

FarmA B

(Skyscraper) (Farm)($1,000,000 FMV; $0 AB) ($1,000,000 FMV; $1,000,000 AB)

Skyscraper

Cash

X(Unrelated 3P)

1

2

52

General Rule – 1031(f)(1)

• If a taxpayer:– exchanges property with a “related person,”– Section 1031(a) otherwise applies to the exchange

(i.e., there is nonrecognition of gain or loss to the taxpayer on the exchange), and

– before the 2-year anniversary of the date of the last transfer that was part of the exchange, either the related party disposes of such property or the taxpayer disposes of the property received in the exchange that was of like kind to the relinquished property,

then the taxpayer loses nonrecognition treatment with respect to the exchange. 53

“Related Person” – 1031(f)(3)

• Under Section 1031(f), “related person” is defined under Sections 267(b) & 707(b)(1).

• Some common examples of related parties include:

– Members of a family (including siblings, spouse, parents, ancestors, and lineal descendants).

– An individual and a corporation in which such individual owns more than 50% of the value of the outstanding stock

– 2 corporations that are members of the same controlled group

– A grantor and a fiduciary of a trust

– An executor and beneficiary of an estate

– A partnership and a person owning, directly or indirectly, more than 50% of the capital or profits interests.

– 2 partnerships where the same person(s) own, directly or indirectly, more than 50% of the capital or profits interests. 54

Attribution• For purposes of determining if persons are related, the attribution

rules of section 267(c) may apply:

• Example:

• Son, through direct ownership only, owns 50% of Corporation (not more than 50%) and is unrelated to Corporation. However, through attribution, Son is deemed to own the 25% share in the Corporation that Father is deemed to own. Thus, Son is deemed to own 75% of Corporation, and Son and Corporation are related.

Corporation

3p

50%

50%

50% 50%

related

Partnership

Son Father

55

“Disposition” Exceptions – 1031(f)(2)

• The following dispositions are ignored for purposes of determining whether a prohibited disposition has occurred within two years: – Any disposition after the earlier of the death of the

taxpayer or the death of the related person,– Any disposition in a compulsory or involuntary conversion

(under section 1033) if the exchange occurred before the threat or imminence of such conversion, or

– Any disposition where neither the original exchange nor the subsequent disposition had as one of its principal purposes the avoidance of federal income tax.

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• According to legislative history, the following transactions generally do not have a tax avoidance purpose:– Transactions involving an exchange of undivided interests in different

properties that results in each taxpayer holding either the entire interest in a single property or a larger undivided interest in any of such properties

– Example: (from P.L.R. 199926045)

• Before:

• After:

Non-Tax Avoidance Purpose - 1031(f)(2)(C)

100% of ½ Timberland

K M

100% of ½ Timberland

3PSale

Timberland

M50%

50%

K

57

• Dispositions of property in nonrecognition transactions.– Example:

• Transactions that do not involve the shifting of basis between parties.

•Example: An exchange of properties that have the same basis.

BrotherSister

Blackacre Whiteacre

3P

Greenacre

Blackacre Blackacre

1 2

Whiteacre Greenacre

58

• Section 1031(a) does not apply to any exchange that is structured to avoid the purposes of the related person rules of section 1031(f).– Example:

• Because these steps are structured to avoid section 1031(f), section 1031(a) will not apply to A’s exchange with X. A must recognize his $1,000,000 gain.

Anti-Abuse Rule – 1031(f)(4)

X

Farm

Skys

crap

erFarm

Cash2 1

A B(Skyscraper) (Farm)

($1,000,000 FMV; $0 AB) ($1,000,000 FMV; $1,000,000 AB)

59

• Caution: Section 1031(f)(1) applies to indirect transfers by related persons through intermediaries.

– Example: (from Rev. Rul. 2002-83)

– IRS ruled that A used QI to circumvent Section 1031(f)(1). Under Section 1031(f)(4), the transaction was recharacterized as a direct exchange of property between A and B, followed by a sale by B to C. Thus related persons cannot use a QI to escape Section 1031(f).

Revenue Ruling 2002-83

C 2

1

QI

4

3

B

Office

$150 Cash

Offi

ceApartm

ents Apartments

$150 Cash

(Apartments: $150 FMV; $150 AB)

A (Office: $150 FMV; $50 AB)

60

• Assume Same Facts:

– This transaction is similar to Rev. Rul. 2002-83, except that B receives like kind replacement property, not cash. Therefore, even if the transaction is recharacterized as a direct exchange between A and B, followed by an exchange between B and D, the transaction falls into the exception for transactions with no principal purpose of tax avoidance (Section 1031(f)(2)(C), per exception for subsequent dispositions in nonrecognition transactions).

PLR 200440002

C 2

1

QI

3

5

B

Office

$150 Cash

Offi

ceApartm

ents

Apartments

Land

(Apartments: $150 FMV; $150 AB)

A(Office: $150 FMV; $50 AB)

D4

Land

$150 Cash

61

Teruya Brothers, Ltd. v. Commissioner• Teruya Brothers, Ltd. (“TB”) owned 62.5% of Times Super

Market, Ltd. (“Times”). Thus, TB and Times were related parties.

• The Ocean Vista Transaction (rounded numbers):

3P 2

1

QI

3

Times

Ocean Vista

$1.5 m cashO

cean Vista +

$1.35m cash

Pad

Sites

$2.85m

cash

(Pad Sites: $2.85m FMV; $1.45m AB)

4

Pad Sites

TB (Ocean Vista: $1.5 m FMV; $100,000 AB)

62

• The Royal Towers Transaction (rounded numbers):

3P 2

1

QI

4

3

Times

Royal Towers

$12m cash

Royal Tow

ers + $600,000 cash

Land

Land

$12.6m

cash

(Land: $12.6m FMV; $17.1m AB)

TB (Royal Towers: $12m FMV; $700,000 AB)

63

• The Court held that TB’s transactions were economically equivalent to direct exchanges between TB and Times, followed by sales of the properties by Times for cash. The interposition of a QI could not obscure the end result. Because the taxpayer offered no explanation for structuring the transactions using a QI, the Court found that TB used the QI to avoid the consequences of equivalent direct exchanges. Thus, Section 1031(f)(4) applied.

• The Court also stated that any analysis under Section 1031(f)(4) into whether a transaction was structured to avoid the purposes of Section 1031(f) must take into account the exception of Section 1031(f)(2)(C) for non-tax avoidance transactions.

• Finally, the Court analyzed the Ocean Vista transaction under Section 1031(f)(2)(C). TB argued that it had less built-in-gain in the Ocean Vista property ($1.345 million after expenses) than Times had in the Pad Sites ($1.35 million after expenses) and therefore the transaction lacked a tax avoidance purpose. However, the Court looked beyond the built-in-gain figures and analyzed each party’s entire tax picture. TB had no NOLs and so would have paid tax on the $1.345 million gain at 34%, whereas Times had NOLs and paid no tax on the $1.35 million gain. Thus, the Court found a tax avoidance purpose.

64

65

Ocmulgee Fields, Inc. v. Comm’r, 132 T.C. 6 (3/31/2009)

– Had TP sold W.S. directly, gain = $6.1m; but if TP and RP exchange, and RP sells W.S. to 3P, gain = $4.3m ($1.8m less).

– Under 1031(f)(4), Court recast as direct exchange between TP and RP, followed by sale of W.S. by RP to 3P. Court then tested 1031(a)(2)(C) exception and found that, due to basis shifting, transaction had principal purpose of tax avoidance. Thus, Court denied 1031 exchange.

3P 2

1

QI

4

3

Related Party

W.S.

$6.8m (net after expenses)

W.S.

B&

N

B&N

$6.8m

(Barnes & Noble Corner: $6.8m FMV; $2.5m AB)

Taxpayer (Wesleyan Station: $7.25m FMV; $700k AB)

Ocmulgee Fields, Inc. v. Comm’r, 613 F.3d 1360 (11th Cir. 2010)

• Under 1031(f)(4), Court recast as direct exchange between Taxpayer and Related Party, followed by sale of Wesleyan Station by Related Party to the third party. The Court then tested 1031(a)(2)(C) exception and found that, due to basis shifting, transaction had principal purpose of tax avoidance.

• Factors: (1) Parties cashed in on the low-basis property, but paid tax only on the gains from the sale of the high-basis property; (2) Related Party’s partners paid tax at only 15%; (3) one partner in related party fully-offset his share of the gain with a charitable deduction; and TP selected Barnes & Noble Corner just 6 days after engaging the QI.

• Notably, Court hinted that lack of basis-shifting could save a transaction under a similar fact pattern.

• See also North Central Rental & Leasing v. U.S., 112 AFTR 2d 2013-7099 (1031(f)(4) applied to equipment exchange; court relied on Teruya and Ocmulgee).

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PLR 201027036

Taxpayer

Related Party Buyers

QI

Unrelated Seller

Equipment

Relinquished Equipment

$100x

$100xReplacement Equipment

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PLR 201027036

• IRS ruled 1031(f)(1) not applicable because Taxpayer exchanged with QI.

• 1031(f)(4) also not applicable because Taxpayer and Related Parties did not exchange properties. Reason: Related Party did not own any property Taxpayer acquired in the exchange.

• [Contrast acquisitions of replacement property from a related party.]

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PLR 201048025 –“Serial Exchanges”

TPRelated Party Affiliate

Third Party

QI QI QI

Buyer

RLP1

RLP1$100x

$100x $100x

$100x

RLP2/RPP1

RLP3/RPP2

RPP3

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PLR 201048025• IRS upheld Taxpayer’s exchange provided all parties remained

invested in replacement properties for at least 2 years. • IRS ruled transactions were valid 1031 exchanges because

related parties did not cash out and remained invested in like kind property.

• IRS relied on exception in IRC Sec. 1031(f)(2)(C) allowing subsequent dispositions that do not have a tax avoidance purpose. Legislative history makes clear that the non-tax avoidance exception includes subsequent dispositions in nonrecognition transactions.

• De minimis boot allowed.

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Example. A and B each own 80 acres of contiguous mineral property, each with a FMV of $100 and basis of $0. State implements a unitization program and forces A and B to combine their 80 acre tracts into one 160-acre unit. A and B each receive a 50% interest in the 160-acre unit. Is this a 1031 exchange? Yes. Rev. Rul. 68-186; GCM 33536.

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Before Unitization After Unitization

A – 80 acres

A – 50%

B – 50%B – 80 acres

Same example, but now assume that A and B are father and son, and that one year later A sells his 50% interest in the unit for $200. The original 1031 exchange may no longer be valid. See IRC 1031(f)(1). Does the “no tax avoidance purpose” exception apply? See IRC 1031(f)(2)(C).

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Before Unitization After Unitization

A – 80 acres

A – 50%

B – 50%B – 80 acres

C

Sale to C for $200