A taxpayer who wishes to avoid paying capital gains tax on realized gain from the sale of property may be able to do so by entering into a Section 1031 Exchange in lieu of a traditional sale. If a transaction qualifies for Section 1031 treatment any capital gains tax that would otherwise be due is deferred. Even if a transaction meets all of the other requirements for a Section 1031 Exchange the transaction may not qualify for deferral of gain if the parties involved in the transaction were “related parties” (as defined by the Internal Revenue Service) and the property involved in the transaction was disposed of within the two year period following the exchange.
Related Party Rule
Section 1031(f) of the Internal Revenue Code addresses related party exchanges. In general, a related party exchange where the property involved in the exchange is disposed of within two years after the exchange does not qualify for non-recognition of gain; however, Section 1031(f)(2)(C) does allow non-recognition of gain if “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)(4) goes on to state that “This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”
In order to avoid triggering the “related party” prohibition, taxpayers often use a Qualified Intermediary, or QI, to facilitate the exchange. By doing so the taxpayer technically avoids entering into a related party exchange; however, the facts and circumstances of the transaction may then trigger Section 1.1031(f)(4) and lead to non-recognition of gain nonetheless.
The purpose of prohibiting related party exchanges is to prevent taxpayers from being able to use Section 1031 to shift the basis in property and then “cash out” shortly after the exchange. Prior to the implementation of Section 1031(f), related parties would often exchange a high basis property for a low basis property and then sell the low basis property for a substantial gain without being required to pay capital gains taxes on the realized gain.
Recent Private Letter Rulings
In both PLR 200709036 and PLR 200712013 the decision to allow non-recognition of gain was based predominantly on the fact that the properties were exchanged for fair market value, taxpayer did not receive a windfall by claiming Section 1031 treatment, and the IRS was convinced that Section 1031 (f)(4) did not apply. In both PLRs it was first determined that the transactions were not related party transactions under Section 1031(f)(1) because the parties used a QI to facilitate the exchange. In addition, the rulings concluded that Section 1031(f)(4) did not apply based largely on the fact that a high basis property was not exchanged for a low basis property, leading to the conclusion that the transactions were not “structured to avoid the purposes” of Section 1031(f).
Tax Court Case
In sharp contrast, the Tax Court, or TC, in Teruya Brothers, Ltd, v. Commissioner, 124 T.C. No. 4 did not allow non-recognition of gain in a similar set of “related party” transactions. In that case the TC acknowledged that the transactions did not qualify under Section 1031(f)(1) for the same reason as PLR 200709036 and PLR 200712013 did not qualify – a QI was used as an intermediary. Unlike the facts in PLR 200709036 and PLR 200712013, however, the taxpayer failed to convince the TC that the transactions were not intended to subvert the purpose of Section 1031(f). On the contrary, the ruling stated:
“The economic substance of the transactions remains that the investments in Ocean Vista and Royal Towers were cashed out immediately and Times, a related person, ended up with the cash proceeds.”
It seems clear that when deciding if a transaction falls under Section 1031(f)(4) particular attention will be paid to the end result of the transaction. In other words, if taxpayer winds up with an economic windfall by “cashing out” as a result of the transaction(s) the court is likely to find that Section (f)(4) applies and not allow deferral of capital gains taxes.
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We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
