Circular Like-Kind Exchange Disallowed

By James Beavers, J.D., LL.M., CPA

The Tax Court disallowed tax-free treatment for a like-kind exchange transaction in which the taxpayer exchanged properties with a related entity.


Ocmulgee Fields, Inc. (OFI) is a corporation that develops, owns, and manages real estate, owned by Charles Jones, his sons Dwight and Jeff, and a partnership owned by the three men. Treaty Fields was a limited liability company in the business of real estate development owned by Dwight and Charles Jones.

In 2003, OFI entered into an agreement with an unrelated third party to sell a property known as the Wesleyan Station Shopping Center. In order to complete the sale as a like-kind exchange, OFI assigned its rights to sell Wesleyan Station to Security Bank as a qualified intermediary for OFI in the sale. Security Bank sold Wesleyan to the third party per the agreement.

After looking at several properties owned by unrelated parties, OFI decided to purchase Barnes and Noble Corner, which Treaty Fields owned, as a replacement property for Wesleyan Station and signed a sale contract with Treaty Fields. OFI had sold Barnes and Noble Corner, which was part of the Rivergate Shopping Center, to Treaty Fields in an earlier transaction. OFI continued to own the rest of the Rivergate property. OFI transferred its rights in the contract to Security Bank and received title to Barnes and Noble Corner.

Treaty Fields reported the sale of Barnes and Noble Corner as a taxable sale. OFI reported its sale of Wesleyan Station and its purchase of Barnes and Noble Corner as a like-kind exchange. The IRS issued a notice of deficiency to OFI based on the transaction, claiming that OFI had structured it in order to avoid tax by circumventing the Sec. 1031(f) prohibition on like-kind exchanges directly between related parties. OFI challenged the IRS's determination in Tax Court.

Sec. 1031

Under Sec. 1031, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment solely for property of a like kind that is to be held either for productive use in a trade or business or for investment. Under Sec. 1031(d), the basis of property acquired in a Sec. 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives and increased by any gain the taxpayer recognizes.

A special rule applies in the case of exchanges between related parties. If a taxpayer exchanges property with a related person and within two years of the last transfer that was part of the exchange the taxpayer or the related person disposes of the property received in the exchange, nonrecognition treatment is not allowed. This special rule does not apply if the taxpayer can establish "that neither the exchange nor the disposition had as one of its principal purposes the avoidance of Federal income tax" (Sec. 1031(f)(2) (C)). However, if a taxpayer structures a transaction to avoid the purposes of Sec. 1031(f), Sec. 1031 will not apply.

The Parties' Arguments

The IRS argued that the case is governed by the Tax Court's decision in Teruya Bros., Ltd., 124 T.C. 45 (2005), a case with a similar fact pattern. In that case, the Tax Court found that the taxpayer included a qualified intermediary in a transaction in an attempt to circumvent the rule prohibiting an exchange directly between related persons, and the taxpayer failed to show that tax avoidance was not one of the principal purposes of the transactions. The Tax Court therefore held that the transactions were structured to avoid the purposes of Sec. 1031(f) and the taxpayer was not entitled to nonrecognition treatment under Sec. 1031(a)(1).

OFI argued that it did not structure the transaction to avoid Sec. 1031(f) because it originally had intended to exchange Wesleyan Station for property owned by a third party and it had a valid business purpose for exchanging for the Barnes and Noble Corner property. According to OFI, having failed to find a suitable property owned by an unrelated party, it chose the Barnes and Noble Corner property because reuniting it with the related property it owned in Rivergate Shopping Center would yield operating efficiencies and would increase the overall value of Rivergate.

Tax Court's Decision

The Tax Court found that in order to determine whether petitioner's exchange with Security Bank was part of a transaction or series of transactions structured to avoid the purposes of Sec. 1031(f), it was required to disregard the actual exchange and consider what the results would have been if OFI had instead exchanged Wesleyan Station with Treaty Fields for the Barnes and Noble Corner and Treaty Fields had then sold Wesleyan Station. In making that larger determination, the court was required to determine whether, under the facts of this deemed transaction, OFI had shown the absence of a principal purpose of federal income tax avoidance.

Having analyzed the deemed transaction, the Tax Court found that the end result of OFI's exchange of Wesleyan Station with Security Bank for the Barnes and Noble Corner was the same as if OFI had made an exchange of Wesleyan Station with Treaty Fields followed by Treaty Fields's sale of Wesleyan Station. The court noted that OFI failed to show that the deemed transaction lacked as a principal purpose the avoidance of federal income tax. According to the Tax Court, the only proof offered by OFI that the transaction was not for tax avoidance purposes was testimony by OFI's owners regarding the purported business purpose for reuniting Barnes and Noble Corner with the rest of Rivergate Shopping Center under the same ownership. Weighing this self-serving testimony against the large tax savings OFI would gain from the basis shift in the transaction if it was treated as a like-kind exchange, the Tax Court found that OFI had not proved that the transaction was not for tax avoidance purposes. Therefore, as it had in Teruya Bros., the court held that the actual exchange was part of a transaction structured to avoid the purposes of Sec. 1031(f) and that the nonrecognition provisions of Sec. 1031 did not apply to the exchange.


The court was very concerned with the issue of basis shifting as an indicator of a tax avoidance purpose. While the court refused to lay down a blanket rule that basis shifting equals tax avoidance, it clearly wanted to close down the opportunity for one party to "cash out" its lowbasis property through the mechanism of a like-kind exchange. Taxpayers will need to be prepared to demonstrate clearly the economic substance of any basis-shifting exchange with related parties if they hope to overcome the inference of tax avoidance that the Tax Court appears prepared to draw.

Ocmulgee Fields, Inc., 132 T.C. No. 6 (2009).

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