Tax Court Rejects Qualified Intermediary Exchange With a Related Party as a Tax-Free Exchange Under Section 1031 in Ocumulgee Fields v. Commissioner, 132 T.C. No. 6 (2009).
The Tax Court in Ocumulgee Fields stated it was not ruling, as a matter of law, that a finding of basis shifting precludes the absence of a principal purpose of tax avoidance, but, in the case at hand, the immediate tax consequences resulting from petitioner's deemed exchange resulted in a $1.8 million reduction in taxable gain and the substitution of a 15% tax rate for a 34% tax rate. Still, the Ocumulgee Fields and Teruya Bros. decisions make it difficult to find a more likely than not basis to qualify a related party exchange through a QI particularly in instances where the related party already owned the replacement property.
The Tax Court’s recent decision in Ocumulgee Fields v. Commissioner, places great stress on the ability of a taxpayer to successfully structure a related party exchange under §1031(f) where the related party transfers the replacement property to the taxpayer through a qualified intermediary. The hurdle is the non-tax avoidance prohibition set forth in §1031(f)(4). Ocmulgee Fields is an important development because it highlights the potential tax risk in acquiring replacement property from a related party. After the Tax Court’s prior decision to the same effect in Teruya Brothers, it was not necessarily clear that the acquisition of replacement property from a related party would, in general, be viewed as "abusive" within the meaning of section 1031(f)(4) .The judicial analysis set forth in Ocmulgee Fields confirms what some had suspected that most acquisitions of replacement property from a related party may be "bad" exchanges and will not qualify for tax free treatment.
As many tax advisors know, §1031(a)(1) provides that no gain or loss is recognized with respect to an "exchange" of property of like-kind. Certain properties described in a parenthetical clause to §1031(a), such as interests in a partnership, stocks or securities, inventory, choses in action, etc., are ineligible for tax-free exchange treatment under this provision. Frequently §1031 is used to exchange real property held for productive use in a trade or business or for investment for property of like kind, i.e., replacement property to be held either for productive use in a trade or business or for investment. The cost for avoiding gain (or loss) recognition under §1031(a) is that the owner of the relinquished property uses the same basis in the replacement property decreased by any money receive and increase by any gain recognized. §1031(d). Other special rules are set forth in the regulations, including rules pertaining to a deferred exchange of property. §1031(a)(3). A deferred exchange will that otherwise qualifies under §1031(a) will in fact qualify where the replacement property: (i) is identified within 45 days of the transfer of the relinquished property; and (ii) such replacement is received by the earlier of 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred.
Treas. Reg. §1.1031(k)-1(g)(4) permits a taxpayer to use a qualified intermediary (other than the taxpayer, the taxpayer’s agent or a "disqualified person"), to facilitate a like-kind exchange. Treas. Reg. §1.1031(k)-1(g)(4)(i). If the various requirements in inserting a qualified intermediary as well as the identification (45 days) and replacement period (180 days) requirements are met, etc., the taxpayer's transfer of the relinquished property to a qualified intermediary and subsequent receipt of like-kind replacement property from the qualified intermediary through a third party acquired with the sales proceeds from the relinquished property, is treated as an exchange with the qualified intermediary.
Section 1031(f) provides special rules for property exchanged between related persons intended to qualify under §1031(a). In pertinent part, it provides that if a taxpayer exchanges property with a "related person", that otherwise qualifies as a tax-free exchange under §1031(a), and within 2 years after the date of the last transfer which was part of such exchange the related person disposes or the property or the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, the prior exchange will be fully taxable. As an exception, §1031(f)(2) provides that the related party recognition rule which overrides §1031(a) will not apply where it is established by the taxpayer (transferor of the relinquished property) 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, and provided that the exchange was not part of a transaction or series of transactions structure to avoid the related party rule in §1031(f).
In Ocumulgee Fields, taxpayer transferred appreciated property to a qualified intermediary (QI) under an exchange agreement in conformity with the requirements under Treas. Reg. §1.1031(k)-1(g)(4), whereupon the QI sold the same property to an unrelated third party and used the sales proceeds to purchase from a "related person" like-kind property that was transferred back to taxpayer to complete the exchange.
The IRS, in assessing a deficiency for the income tax on the gain realized from the taxpayer’s receipt of the replacement property, argued that the exchange was part of a transaction structured to avoid §1031(f) and did not make the "lack of tax avoidance" exception under §1031(f)(2)(C) absent credible proof. The Service viewed the interposition of the QI was to reflect a significant basis shifting in the taxpayer’s holding and an immediate cash out that resulted in substantial tax savings.
The Tax Court agreed with the Service and found taxpayer's claim of "no tax avoidance" purpose unpersuasive and concluded that the end result of actual exchange involving QI was the same as if the taxpayer had made the exchange directly with the related person followed by the related person’s making an outside sale to a third party. In essence the taxpayer failed to carry its burden of proof of the absence of a principal purpose of tax avoidance. In Teruya Bros., Ltd.. & Subs, 124 T.C. 45 (2005), aff’d 104 AFTR 2d 2009 (9th Cir. 9/8/09)
Note: the taxpayer negotiated the sale of relatively low basis real property to an unrelated person through a QI structure, same as in the Ocumulgee Fields case. In anticipation of the sale, the taxpayer arranged to purchase relatively high basis replacement property from a related person. To carry out the transaction, the taxpayer arranged for a qualified intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated person, to use the proceeds to purchase the replacement property from the related person, and then to transfer that replacement property to the taxpayer. On a related note, Teruya Bros. was just affirmed by the 9th Circuit in upholding the Tax Court’s denial of §1031(a) treatment.
