US Tax: Appeals court defines application of section 1031(f)(4) to related-party exchanges

The Ninth Circuit on September 8 affirmed a Tax Court decision holding that a corporation was not entitled to defer, under section 1031, gains realized on planned four-party exchanges of real properties through an intermediary, because the transactions violated section 1031(f)(4). (Teruya Bros. Ltd. v. Commissioner, No. 05-73779 (9th Cir. Sept. 8, 2009).)


Background

Section 1031(a)(1) allows a taxpayer to defer gain on the exchange of like-kind property, but section 1031(f) largely precludes this beneficial treatment when a taxpayer exchanges like-kind property with a related person and either party disposes of the exchanged property within two years. Section 1031(f)(4) provides that a taxpayer may not claim nonrecognition treatment under section 1031 for any exchange that is part of a transaction or series of transactions "structured to avoid the purposes of" section 1031(f).

However, section 1032(f)(2) provides several circumstances under which a related-party exchange may qualify for nonrecognition treatment despite technically violating section 1031(f)(1). Section 1031(f)(2)(C) allows otherwise improper exchanges to earn nonrecognition treatment where "it is established to the satisfaction of the Secretary that neither the exchange nor [the subsequent] disposition had as one of its principal purposes the avoidance of Federal income tax."


Decision

The Ninth Circuit agreed with the Tax Court that the prearranged purchase of replacement property from a related party after the taxpayer's sale of relinquished property using a qualified intermediary (QI) was, in effect, the same as if the taxpayer and the related party had first exchanged the properties and the related party had then sold the taxpayer's former property. Regarding the interplay of section 1031(f)(2) and 1031(f)(4), the Ninth Circuit wrote, "[s]ection 1031(f)(4) denies nonrecognition treatment only to those transactions that violate section 1031(f)(1)'s purposes. As transactions falling within section 1031(f)(2)'s exceptions by their very nature do not violate those purposes, section 1031(f)(2) must independently limit section 1031(f)(4)'s scope. In other words, a transaction does not violate section 1031(f)(4) if the taxpayer can establish 'to the satisfaction of the Secretary' that the transaction did not have 'as one of its principal purposes the avoidance of Federal income tax'"; but the taxpayer failed to do this.


Implications

The Ninth Circuit's decision confirms a basic caveat in planning any section 1031 exchange: taxpayers should generally not plan to acquire any property owned by a related party as replacement property in an exchange. The only exception would be where the related party itself is doing its own like-kind exchange. In other words, if a taxpayer owns Property 1 and wants to sell it to an unrelated buyer, and a related party to the taxpayer owns another Property 2, then:
- A taxpayer cannot exchange its Property 1 for Property 2 owned by a related party, followed (within two years) by the related party selling Property 1 to an unrelated buyer.
- In the alternative, the taxpayer cannot sell Property 1 to the unrelated buyer, place the funds with a QI, and have the QI buy Property 2 from the related party.

An exception to the second rule will apply if (but only if) after selling Property 2 to the QI, the related party does its own exchange by using a QI to take the proceeds from the sale of Property 2 and acquire Property 3 from an unrelated party.

Note that these limitations do not apply if the related party has cash and simply wants to purchase Property 1 from the taxpayer. In that case, the taxpayer can complete a valid section 1031 exchange despite the relationship to the related party by buying Property 3 from an unrelated party.